BQ Explains: Stagflation — What, When And What If...

Retail inflation in India surged to a five-and-a-half year high of 7.35 percent in December as vegetable prices surged. The data reported on Monday came days after the government’s statistical office confirmed that India’s GDP growth in 2019-20 is likely to fall to 5 percent.

While 5 percent growth would be considered acceptable for many economies around the world, it is seen as well below potential for India, which at the start of the 2010s was hoping to achieve double-digit growth.

When that weak growth gets combined with a rise in inflation, economists start to worry about temporary stagflation-like conditions and its consequences.

What is Stagflation?

Stagflation is a combination of stagnant economic growth, high inflation and high unemployment. Given what it brings with it, stagflation is not characteristic of a well functioning economy. Normally, slow economic growth prevents consumer demand from rising, causing inflation to remain low. At a time of stagflation, demand is weak but inflation is high.

A now famous example of stagflation comes from the U.S., when the country pulled out of the Bretton Woods agreement in 1971. One consequence of this was that import prices rose and growth slowed. A 90-day freeze on wages and prices left American companies with no choice but to layoff workers, pushing up unemployment. This was at a time when the U.S. was facing an oil embargo, leading to high inflation rates.

The Phillips Curve — the stable and negative relation between inflation and unemployment — didn’t hold true at the time and the American economy saw stagflation. Eventually, the Federal Reserve raised rates to curb inflation but sent the economy into a recession

Keynes vs Friedman

The U.S. episode of stagflation also bought into conflict two popular economic theories — those of John Maynard Keynes and Milton Friedman.

Those who follow Keynes, aka Keynesians, believed in the stable and inverse relationship between unemployment and inflation. If the economy slows, unemployment would rise and inflation would fall. Stagflationary conditions do not fit in with that thinking.

However, Friedman, with a paper in 1968, debunked the theory of a stable relationship between unemployment and inflation. He argued that supply-side shocks can indeed lead to stagflation, as inflation feeds into inflationary expectations and allows price pressure to become more permanent. In such a situation, central banks must work to control inflation while governments should deregulate to promote growth.

The period of stagflation in the U.S. gave more credence to Friedman’s theories.

Is India Facing Stagflation?

Back home in India, the spike in inflation and the sharp drop in growth rates have prompted the question — Is India facing stagflation?

Former Prime Minister Manmohan Singh, also a former governor of the Reserve Bank of India, wrote in November that India needs to be watchful of the build-up of stagflation-like conditions. “While we are currently not in stagflation territory yet, it is prudent to act quickly to restore consumption demand through fiscal policy measures since the impact of monetary policy seems muted,” Singh wrote in an editorial in the Hindu newspaper.

Economists who cover India are divided.

Nomura economists Sonal Verma and Aurodeep Nandi see stagflation-like conditions but said they were temporary. “We believe stagflationary conditions will be temporary, underpinned by our expectation that supply-side pressures will soon subside, and the consumption shocks will further depress core inflation,” they wrote in a note following Monday’s inflation data.

Pranjul Bhandari, chief India economist of HSBC India, said, “While there are definitely growth worries, we should not be overly concerned over stagflation.” Inflation has inched up and is likely to remain high for the next couple of months. Inflation is currently not generalised and is expected to ease by the middle of 2020, she said. Growth, too, is close to bottoming out and it is not likely to slide further, though it is not expected to sharply improve either, Bhandari said.

India’s Monetary Policy Committee paused a year-long interest rate cutting drive in December, citing the need for more data on the inflation front. It also said that it awaits fuller transmission of the 135 basis points in rate cuts already announced. It, however, termed its pause as temporary.

The committee, when it meets next in February, will make a judgement on when the low growth-rising inflation scenario leaves room for more rate cuts. The legal mandate of maintaining inflation at 4 (+/-2) percent may mean that rates stay on hold till the committee has enough visibility on inflation coming back down to the 4-percent-mark. As a consequence, the burden to revive growth may fall on the government, which may need to look beyond fiscal pump-priming, to spur economic momentum in the economy.