Print Friendly, PDF & Email

Insights into Editorial: Is the Indian economy staring at stagflation?

Insights into Editorial: Is the Indian economy staring at stagflation?

A_fresh_crisis

Context:

The rise in retail price inflation to a nearly six-year high of 7.35% in December has led to increasing worries that the Indian economy may be headed towards stagflation.

The current rise in retail inflation has been attributed mainly to the rise in the prices of vegetables such as onions.

Still, the steady rise in wider inflation figures over the last few months amidst falling economic growth has led to fears of stagflation.

What is stagflation?

Stagflation is an economic scenario where an economy faces both high inflation and low growth (and high unemployment) at the same time.

The Indian economy has now faced six consecutive quarters of slowing growth since 2018.

Economic growth in the second quarter ending September, the most recent quarter for which data is available, was just 4.5%. For the whole year, growth is expected to be around 5%.

Most economists have blamed the slowdown on the lack of sufficient consumer demand for goods and services.

In fact, insufficient demand was cited as the primary reason behind the low-price inflation that was prevalent in the economy until recently.

Subsequently, the government and many analysts prodded the Reserve Bank of India (RBI) to cut interest rates in order to boost demand.

This led to significant friction between the government and the RBI that led to the exit of several top-ranking officials (including the RBI’s former Governor) from the central bank.

Eventually, the RBI obliged by cutting its benchmark interest rate, the repo rate, five times in 2019.

However, Decrease in repo rate, Growth rate not rising:

The growth rate of the economy continued to fall significantly.

This combination of rising prices and falling growth has led many to believe that India may be sliding into stagflation.

Perhaps the only thing right now that stops many from concluding that the economy is in full-fledged stagflation is the fact that core inflation, which excludes items such as vegetables whose prices are too volatile, remains within the RBI’s targeted range.

Why is stagflation a problem?

  • On the one hand, the slowdown in growth could affect peoples’ incomes. On the other, higher inflation could cause a reduction in people’s standard of living as they can afford fewer things.
  • Economists who believe that the current slowdown is due to the lack of sufficient consumer demand prescribe greater spending by the government and the central bank to resuscitate the economy.
  • But stagflation essentially ties the hands of the government and the central bank from taking such countercyclical policy steps.
  • With retail inflation now well above the RBI’s targeted range of 2-6%, the central bank is unlikely to assist the economy any time soon by cutting its benchmark interest rate.
  • If the central bank decides to inject fresh money into the economy either by cutting its benchmark interest rate or other unconventional means, it could lead to a further rise in prices and make things worse.
  • A similar rise in inflation could result if the government engages in deficit spending that is funded by the RBI.
  • With both the private consumption growth and investment rate dropping below 5% in Q1 FY2020, the GDP growth rate has fallen to 5%.
  • Nominal GDP growth has slid to 8%, a record low. Growth in employment intensive sectors such as manufacturing and construction has also been muted.
  • All this is considered to be bad news at a time when the economy, with significant unemployed resources, is not functioning at its full capacity.

 

Other set of Economists argue that Economy will be boosted by the availability of easy credit:

  • Some economists even see the severe drop in consumer demand simply as a symptom rather than as the primary cause behind the current slowdown.
  • Another point raised by these economists is that inflation on the broader level, as measured by the core inflation figures, remains within the RBI’s target range.
  • Core inflation in December was at 3.7%. So greater spending by the government and the RBI will not cause inflation levels to run out of control, they argue.
  • According to this view, it is natural for spending to drop after the end of a credit-fuelled boom.
  • India’s growth rate, it is worth noting, was boosted by the availability of easy credit over the last decade, or even longer.
  • Others, however, are more cautious about advocating a big-spending approach to rescue the economy from stagflation. They point to the fact that monetary easing in the last one year has only raised prices without leading to higher growth rates.
  • So, injecting further liquidity into the economy may only stoke higher inflation without boosting economic growth.
  • Further credit expansion by the central bank and debt-fuelled government spending, these economists argue, will not lead to genuine and sustainable economic growth but only to another unsustainable boom followed by a bust.
  • So, they instead advocate supply-side reforms to bring about genuine economic growth.

 

Conclusion: Supply-side reforms:

Supply-side policies are government attempts to increase productivity and increase efficiency in the economy.

If successful, they will shift aggregate supply (AS) to the right and enable higher economic growth in the long-run.

Free-market supply-side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.

Interventionist supply-side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.

Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.

Improved trade and Balance of Payments, by making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace.