Is India on the brink of the next Great Stagflation?

High inflation coupled with slow GDP growth is never a good sign – yet one that India is faced with right now

India today stands at the brink of prolonged economic stagflation. The repercussions will be massive – and the onus to mitigate further supply shocks to keep the economy stable for the medium and long runs rest firmly on the shoulders of its policymakers.

Figure 1: Inflation Rates, India

The parable of improper policy work

About half a century ago, an economic concept called the “Philips Curve” was at its peak. Essentially an association between inflation and unemployment, Kiwi economist A.W. Phillips claimed that the two shared a stable and inverse relationship when plotted against each other. One can see the merits behind the popularity of the observation – if economic growth is high, inflation will be steadily on the rise, and the concurrent opening up of jobs will keep unemployment levels low.

Such was the popularity of the Phillips Curve, in fact, that US President Richard Nixon – having assumed office during a period of recession – even leaned on it for most of his policy proposals. He tried to boost the economy by raising inflation rates, hoping for lowered unemployment and a second term in office in the process. The effect on the economy was palpable and instant.

The was a steady decrease in the unemployment rate and an unsteady rise in the inflation rate, until several factors such as the end of the Bretton Woods System (attaching of the value of the dollar to the gold standard) and the Arab Oil Embargo of ‘73, among several others, colluded to cause devastating effects. Inflation rates levels rose monumentally – along with unemployment levels – and marked the advent of a period regarded as the ‘Great Inflation’. In hindsight, 1974 turned out to be a rather bleak year for Nixon – not only did he not get a second term in office, but he also managed to drive the United States to its first period of negative economic growth in almost two decades.

Economists around the world – primarily of the major market economies – were faced with a grave challenge at the time. The challenge, primarily, was to deal with a portmanteau first coined by a British Conservative politician in Parliament in 1965 – ‘stagflation’.

Stagnation + Inflation

Stagflation, in essence, offers the worst of two worlds – a high inflation (and unemployment) rate concurrent with a period of slow economic growth. It is a paradox of sorts for policymakers, as, according to conventional economic theory (and the Philips Curve), actions taken to reduce one may end up exacerbating the other.

Economists generally identify two principal causes for stagflation: (1) at the bureaucratic level, where the creation of policies deter the growth of industries while simultaneously pushing for greater money supply in the economy and (2) when economies face supply shocks, an event that raises average price levels while simultaneously slowing down economic growth owing to increased costs of production and lesser profitability.

Figure 2: 1970s cartoons depicting ‘Reaganomics’

Another aspect to consider is the transmission mechanism of monetary policy. Quite remarkably, Central Banks aim to control the economy’s inflation rate through the manipulation of short-term interest rates, i.e. the setting of monetary policy. If interest rates are reduced, it would imply commercial banks have greater incentive to borrow from central banks and give out loans – an event that, in the short run, is expected to spur on economic growth, reduce unemployment through greater job creation and therefore increase price levels (i.e. inflation) owing to the higher money supply in the economy.

In economic theory, this is referred to as an inflationary gap. And, the prescribed way to deal with an inflationary gap is to force the reduction of aggregate demand through ‘contractionary’ fiscal policy from the government. Now, this is going on the presumption from theory, that the economy is already lying on a point of excess demand, caused by a supernaturally high GDP. Currently, however, the case is the exact opposite. And, this is where the trouble lies for India, going ahead.

Misplaced Optimism?

India today stands at the precipice of being a contracting economy whilst facing high price levels and unemployment rates. This is, of course, untenable for the future – and puts India in the unenviable position of being in a period of stagflation. Omens turned sourer when the Reserve Bank of India governor, ShaktiKanta Das, recently opined that “the outlook for inflation has turned adverse”.

Figure 3: GDP Growth Rate Projections, India; SOURCE: OECD

Inflation rates in India currently stand at a six-year high of 7.6%, whilst GDP growth rates have just come off of historic lows of about -24% and -7% in consecutive quarters. The coronavirus pandemic has brought about historic contractions to the Indian economy, forcing the Central Bank to hold interest rates low and steady over the past few months in spite of rampant inflation.

Currently, a massive increase in food prices has been cited as the primary point for the rising inflation levels in the country.  According to the Financial Times: “Food inflation has long proved to be a politically sensitive issue in India. High prices of staples such as onions, for example, have been associated with the fall of governments.”  With food inflation levels currently standing at about 11% in India and supply issues being strained by several socio-political factors, the central bank will have to maintain an ‘accommodative’ stance with monetary policy and quantitative easing measures in order to stabilise issues going forward.

Consensus, however, seems to be moving in a positive direction. RBI governor remains ‘optimistic’ of the economy showing ‘nascent signs’ of recovery, projecting a positive growth factor of about 0.1% in the current quarter. The manufacturing sector has, in fact, recovered much faster than expected and continuous liquidity measures have provided support to several struggling industries.

According to an article from the Financial Times: “Capital Economics said in a note on Friday that it expected inflationary pressures to ease in the coming months as disruption to supply chains caused by coronavirus restrictions were resolved. But it added that growth would suffer in the long term, as the pandemic exacerbates weaknesses in India’s economy, such as a banking sector hobbled by one of the world’s highest bad-loan ratios.”

“The economy will still suffer repercussions from the crisis over the coming years”, according to consulting firm Capital Economics, “that will prevent a rapid return to the pre-crisis GDP trend.”

The next few months could prove to be pivotal for the future of India’s economy.