Simultaneous opposite trends may set off alarm bells, but the economy may still weather the storm.
By: Tavaga Research
The confluence of opposites may give us something as beautiful as a rainbow or it may stump us with something like stagflation.
For those of us scanning the news these days, the word is no stranger. It comes up everytime someone discusses the current state of the economy. But are we there yet?
What is stagflation?
The meaning of stagflation (in economics) will help us get started on understanding whether we are in the middle of it or not.
Stagflation may be defined as a time of simultaneous high and rapid inflation and high unemployment and slowdown in growth in the economy.
While there are conflicting claims of who coined the term stagflation, combining stagnation and inflation, it seems to have been first used by Iain Macleod, a British politician, in 1965, in a speech in the British Parliament.
It was, however, brought into currency when Nobel laureate and American economist, Paul Samuelson used it to describe the situation in the seventies and eighties in America.
Macleod had declared earlier the House of Commons, “We now have the worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation.”
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What are the causes of stagflation?
Stagflation is not a frequent phenomenon. It is caused by extraordinary circumstances. Even though a Britisher had used it first, it was America in the seventies and eighties that had to weather a full-blown stagflation. The US’ economy at that time would be the most prominent stagflation example.
The extraordinary cause behind it? Oil prices that shot up and created a supply-side shock.
As crude oil prices rose, the cost of production including transport cost and operating cost rose, leading to rapid rise in output/product cost and hence, inflation. The economy had a lenient monetary policy with low rates, which ran the risk of inflation to begin with. The ensuing high prices lowered the consumption demand in turn (high prices acted as a deterrent), pushing the economy towards a recession.
The US central bank, the Federal Reserve, flip-flopped between raising the interest rate (to stem inflation), lowering it (to spur growth) and then raising it again to tackle any one of the problems, at a time.
Thus, inflation caused by a high supply cost than by excess demand in the economy might lower demand, and slow down the economy, leading to stagflation.
Which inflation leads to stagflation?
Inflation can have four main drivers.
There is the cost-push inflation, or the decrease in the supply of goods and services, stemming from a disproportionate increase in the cost of production. Rise in input costs like increasing crude oil prices trigger this.
The other is the demand-pull inflation, or the disproportionate increase in demand, caused by the four drivers of GDP — private consumption, savings, government spending, and exports.
The third and the fourth triggers of inflation are the disproportionate increase and decrease in the money supply of the economy, regulated by the central bank.
Stagflation is driven by a cost push, where the prices of the goods and services rise even when the economy slows down.
Stagflation in India
India is seeing inflation and recessionary pressures at the same time. The effects of stagflation-like symptoms such as unemployment, lack of investment, curtailed government spending and factory production are plaguing the country. At the same time, India is battling high retail-price and wholesale-price inflation.
Retail inflation was at 7.35 percent, as on December, 2019, the highest since July, 2014.
We are, then, saddled with second-quarter (of fiscal 2020) GDP growth at 4.5 percent and retail inflation well above 5 percent.
At the root of India’s inflation
Basic necessities such as food and beverages are key to our CPI or retail inflation basket, comprising 45.86 percent of the metric. Compared to 8.9 percent in November, 2019, the category clocked 12.16 percent, its highest since December. 2013.
Vegetable prices surged by 60.5 percent in December over the year before, compared to a rise of 40 percent in November. Onion prices, which rose by over 300 percent from a year ago, remain the biggest pain point in the food category. But things could look up as crops are cyclical in nature and their supply would increase in the peak season. For example, onion prices have dogged inflation numbers in previous years as well.
But the longer food prices take to settle back down, the greater the socio-economic pressure on a population like ours where basic necessities are luxuries among large swathes of people.
The chart below shows the way food inflation has left the overall CPI behind:-
Source: RBI, Tavaga Research
The dilemma of RBI
Monetary policy of RBI remains a key tool to balance forces of instability in the economy. However, the current situation has underlined its ineffectiveness in certain cases. RBI has already cut the key interest rate, called the repo rate, five times in a year’s span.
A low interest rate can only fan the inflation flames. But RBI was betting on tackling the other end of the stagflation-like crisis – stagnation. Lowe rates would help on stoking manufacturing growth and new business growth, and create more jobs, afterall.
But not only has inflation continued unabated, growth remains muted. Experts have pointed to the need for structural changes. For example, the dearth in demand in rural areas is a major inhibitor of growth. Interest rate changes will help little and hence, have not been able to move the needle.
Structural gaps
The need of the hour in rural India is for farmers, the real producers of farm produce, to receive a better price themselves, rather than middlemen pocketing fat commissions.
Of the retail price paid on perishable primary food items such as vegetables and fruits, the average share farmers earn is a mere 28-30 percent.
An improvement in the supply chain, starting from the farm, is largely considered as the key step to promoting inclusive growth as this can increase the share farmers get from the cost of food products paid by consumers.
Rather than government loan waivers, better access to quality credit, that is not exploitative, remains another pressing need but has foxed successive governments.
Solutions to stagflation
There is no easy solution to stagflation.
Monetary policy can try to either reduce inflation (with higher interest rates) or to increase economic growth (by cutting interest rates), but not address both inflation and recession at the same time.
In the long run, reducing the country’s dependence on oil imports will make the economy less vulnerable to stagflation. India imports around 84 percent of its crude oil, so a global increase in the price of crude oil will leave little for the government to do.
The only real solution is supply-side policies to increase productivity, that would enable higher, intrinsic growth without inflation.
The call for structural policy reforms is getting louder with time. The reforms which would help India grow include labour reforms, reforms in the agricultural sector (for fair price and farm to fork supply chain) and in the financial sector (for greater inclusivity and transparency). The time for stop-gap stimuli, either form RBI or the central government seems to be over.
The government has resorted to stimuli that could have worked at other times such as the $20-billion-corporate-tax cuts.
Privatisation of public-sector enterprises is another step that could alleviate the mood but is not an easy task to pull off.
By selling state assets, much needed funds for greater government spending (on capital creation) would come in, while inefficiently-utilised key resources with the government would clock better efficiencies and generate more growth and employment.
Think Air India and its dismal performance over the decades. The inefficiencies have reached such proportions that government aid is proving to be insufficient and finding a bidder an uphill task.
Stagflation affects the Phillips curve
How does stagflation affect the Phillips curve? The Phillips curve, a concept in economics, says inflation and unemployment (a result of stagnation) share an inverse relationship.
Stagflation disrupts this conventional wisdom. the curve itself shifts to the right indicating higher inflation and higher unemployment.
The stagflation of the seventies
The US economy in the seventies was characterised by rising oil prices, high levels of inflation, unemployment, and the recession.
In the seventies, the US economy was going through a mild recession, its GDP growth was negative for three quarters, and unemployment was rising, and President Nixon was running for re-election (in 1972).
Nixon announced a host of fiscal stimuli to encourage growth without triggering inflation. But the measures backfired — the GDP worsened and inflation reached uncontrollable levels.
Adding to the perfect storm, in 1973, was OPEC (Organisation of the Petroleum Exporting Countries) which reduced its oil exports, pushing the US economy to stagflation.
How did stagflation affect the Indian economy?
It may be premature to declare the Indian economy is in full-blown stagflation. Of course, the stagflation-like pressures are only too real and continuing for some time.
Some of the pressure points are cyclical in nature. The high inflation, driven primarily by onion prices, would be temporary as it is a 90-day crop.
Crude oil prices fell on the news of easing US-Iran tensions and it could bring further relief to our economy.
How can we protect ourselves from stagflation?
While waiting for things to look up, what can we do at our end?
All investments ultimately need equity stocks to improve as most market instruments are derived from the premise of companies doing well and spurring growth on. However, during a stagflation we can concentrate more on traditional assets classes while we wait for manufacturing prospects and companies’ outlook to pick up.
We may consider increasing our allocation in commodities, such as gold and energy. In equities, we may look to technology companies as their business driver is innovation and they may somewhat be shielded from the inflation and unemployment gloom.