Stagflation- A Theory or Future Reality

The Government of India and Reserve Bank of India have been caught in a Catch 22 conjunction since the advent of COVID-19. While the Indian economy has been facing a slowdown since 2017-18, the impulsive shocks to the Growth happened with the nationwide imposed lockdown during Covid.

In an immediate response to keep domestic firms operationally afloat during the stringent lockdowns and specifically maintain employment rates, GOI and RBI in sync opened up their taps of generosity and flushed the Economy with cash and kind.

While these steps were necessary at times when hope looked bleak, today these are costing us in the form of Inflation. With Demand projections yet to pick up for the coming quarter’s uncertainties, there are growing murmurs of Stagflation.

“The primary objective of Monetary Policy is to maintain price stability while keeping in mind the objective of growth. Price stability is a necessary precondition to sustainable growth.” – as per Inflation Targeting Framework implemented by RBI amendment Act 2016. But for the past 12 months, the retail inflation has been outside and above the RBI’s mandated band of 2-6%. Also, in its latest Bi-monthly Review held in Dec-2020, the inflation outlook has been set at even worse – “Headline consumer price index (CPI) inflation is expected at 6.6 percent in Q3:2020-21, but moderate thereafter to 4.5 percent by Q2:2021-22; the inflation projections have been revised up for all the four quarters when compared with the previous survey round”.

In the latest Consumer Confidence Survey by RBI, in the year ahead, consumers are optimistic about every macroeconomic variable barring the issue of prices. Supply-side shocks due to COVID and a gradual surge in taxation on oil poses a concern to Inflation. Faced with plunging revenue concerns and collapsed oil prices in the first quarter of the year, the Central government hiked fuel excises which now is expected to make up 25% of the share in total revenues of FY21.

The liquidity in the system is also at an all-time peak. The RBI has been on a liquidity infusion spree recently. It reduced the repo rate by 115 basis points since March’2020 and launched Targeted Long Term Repo Operations worth Rs 1.5 lakh crore. These steps have injected huge liquidity into the economy.

The Indian economy has been losing growth momentum for three consecutive years beginning 2017-18. GDP growth was 8.3% in 2016-17. It fell to 7% in 2017-18, 6.1% in 2018-19 and 4.2% in 2019-20. Reasons for the slowdown are the fall in private consumption, lack of investments, the global slowdown, stagnant exports.

The Government’s response had been one to the supply side- slashing corporate taxes in Sept’19, giving subsidies to firms with Production Linked Incentive Scheme, Labour reform, and Agricultural Marketing Reform. In tandem with the government, the RBI kept its policy stance at stable rates to promote investment and boost Gross Fixed Capital Formation.

RBI in its latest Bi-monthly policy revised its forecast of economic growth for the current 2020-21 fiscal year to (-) 7.5% as against its earlier forecast of (-) 9.5%, maintaining an accommodative stance for growth. Looking at key factors still holding back growth, first being Uncertainty. With the rising coronavirus cases, the effectiveness of developed vaccination, supply, and production constraints to reach out vaccination in near future, and a variant of COVID virus now making news into the Indian territory brings up a lot of downside variables into play. Hence, consumers are saving money rather than spending so as to save for future risks, also corporates are not investing due to lack of demand. Secondly- the liquidity generated in the system by fiscal stimulus and monetary policy is actually not put to impact since the transmission of credit to the needed strata still remains a challenge.

The risk-averse banks have been parking a huge chunk of money with RBI at the reverse repo, which has shot up to 6.6 lac crore 31-Dec-20 from 51k crore last year. Thirdly- Lack of enough Fiscal Stimulus. The government announced the Atmanirbhar Bharat Package worth 21 lac Crores Rs., which has mostly been a Bank Credit for businesses.

The government transferred money to farmers and holders of Jan Dhan account but the amount was too small to make an impact on demand for individuals. India’s fiscal deficit stood at Rs 10.75 lakh crore at the end of November, 35% higher than the budget estimate for FY21.

The government’s debt rose to 75 percent of GDP in FY20 from 70 percent in FY18, hence did not observe high direct transfer benefits in Atmanirbhar Bharat Scheme. It is seen rising further to 91 percent of GDP in FY21 and peak at 91.3 percent of GDP in FY22.

Stagflation (when the slowdown in the economy is further aggravated by rising inflation) which just stands as a theory today, could be the reality a few quarters down the future. Since a consistent inverse relationship is held between rising prices and rising unemployment (as studied by A.W.H. Philips), both monetary and fiscal policy could individually control one moving part in any period in time.

Economists argue that inflation targeting should be led from the supply-side, to increase Aggregate Supply via Privatisation and deregulation to increase efficiency and reduce the cost of production. The government should come up with a credible privatization plan to sell public sector units and the funds generated from that should be used effectively to create quality infrastructure.

Controlling Food Prices holds key to ease up inflation problem. Central Bank should ideally maintain interest rates. To pull the excess liquidity in the system, RBI can probably raise reverse repo in the short-term, squeezing the spread with Repo. These effective policy steps by both government and RBI can boost India’s growth while simultaneously taming inflation.

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