India macro tidings: Return of stagflation?

India macro tidings: Return of stagflation?

By Yuvika Singhal, Vivek Kumar and Shubhada Rao

With GDP over FY21-22 likely to almost flatten out and CPI inflation being close to RBI’s upper band of comfort for two consecutive years, the narrative of stagflation is making a strong comeback in popular economic discourse. Let’s take a look at structural inflation impulses from the perspective of aggregate demand and supply, in a post-Covid economy. Is stagflation coming back?

The genesis of stagflation is rooted in a negative aggregate supply shock, akin to the one induced by the Covid-19 pandemic in recent times. An objective assessment of consequent inflation, tells us that bulk of it is supply-driven which could turn out to be transitory as supply disruptions ease. But swift progress on vaccination may trigger demand-pull inflation as we near the end of 2021, with growth recovery gathering pace. For stagflation to take hold, inflation must seep into the economy via a wage-price spiral.

We argue that this may be difficult to transpire in India in the near term owing to a restrained but well-targeted fiscal response along with a persistent labour market slack and undermined bargaining power of workers. Having said so, we need to be mindful that a possible breakdown of free-market forces via – rise in the market power of larger firms as smaller ones succumb to the pandemic, and an import substitution policy – that may have an unintended impact of upward price adjustments in the post-Covid economy.

Amidst such dynamics, RBI will have to attend to higher inflation perhaps sooner than later. Thus, the baton of restoring growth via a push to aggregate supply will have to be passed on to the Government without much delay.

Stagflation is a combination of two words – stagnation and inflation.

Stagflation is a combination of two words – stagnation and inflation. At various points in time in the past, a combination of receding growth and higher inflation in India has been loosely (and hurriedly) labelled as a situation of stagflation. Unsurprisingly, with GDP over FY21-22 likely to almost flatten out and CPI inflation being close to RBI’s upper band of comfort (i.e., of 6.0%) for two consecutive years, the notion of stagflation has made a strong comeback in popular economic discourse with a growing sense of foreboding.

Stagflation: A stylized look back at economic history

Stagflation is a concept not as simple as it appears. Its 1970’s incarnation in the US (and other developed markets) altered the course of macroeconomic thinking (Keynesian economics gave way to monetarists, with the debunking of the Phillips curve) and also conduct of monetary policy (adoption of inflation targeting later), which remains unchallenged till date. The genesis of stagflation, back then, was rooted in the oil price shock (not once but twice, in 1973 and 1979) which created a negative aggregate supply shock.

As a consequence, inflation shot up and so did unemployment as growth sank, with the former getting entrenched via the wage-price spiral that ensued. Since a push to aggregate demand remains literally ineffectual in such a situation (for it perpetuates inflation), what followed in the US was Volcker’s stiff tightening of interest rates in a bid to bring inflation under control which pushed the economy into recession.

Basic economic tenets for stagflation missing, at present

At the current juncture, the biggest similarity that we are facing with history is a recurrence of a supply shock; this time however owing to a hitherto unimaginable pandemic. But the similarity stops there. While we have seen a rise in inflation owing to supply disruptions in India and elsewhere, but for western-style stagflation to take hold, it must seep into higher wages leading to an upward spiral in prices, as firms raise prices again to maintain margins.

This appears to be a tad difficult to transpire in India despite expectations of the preponderance of vaccine led demand-pull inflation taking precedence in H2 FY22, basis three arguments –

1) A restrained but well-targeted fiscal response

Compared to developed economies that have relied on unprecedented expansionary fiscal policy to support their economies in the pandemic, India’s fiscal response has been restrained in comparison. This in some sense, serves well, as a push to aggregate demand (at a time when aggregate supply has shrunk) can prove inflationary. In the US, this is being witnessed in a high concentration of upward price pressures in select sectors that are rebounding from the pandemic.

While it can be a case of pent-up demand at play, but not be without a leg up accorded by fiscal transfers that remain in place. Having said so, fiscal policy has a bigger role to play to correct income inequalities – an undesired fallout of the pandemic. In this spirit, RBI measures and Government transfers predominantly targeted towards the marginalized sections of both consumers and businesses should be seen in a positive light.

2) A drawn-out labour market slack

The concept of full employment or for that matter NAIRU (NonAccelerating Inflation Rate of Unemployment) has no application in a developing economy, such as India. This is because underemployment, structural and frictional unemployment are deep-seated. The pandemic has complicated this further via a reduction in labour force participation rate (especially of elderly and women) and reverses migration of labour.

What this essentially means is that even as GDP gradually reverts to pre-Covid levels by end of FY22, unemployment despite correction is unlikely to drop below the tipping point, thereby precluding an upward acceleration in wage-led inflation. And, not to forget the hastening of automation and mechanization heralded by the pandemic, may work to exacerbate this labour market slack.

3) Low collective bargaining power of workers

In another perspective of the labour market, one trend that has transpired progressively over the last few decades is the decline in the unionization of workers and their collective bargaining power. This is true globally and for India. Stansbury and Summers (2020) rightly point out – “Employment protection laws have become looser, the minimum wage has decreased, trade union density and collective bargaining coverage have fallen, globalisation has made workers more vulnerable to threats of job loss due to delocalization”.

Record growth in corporate profits in FY21 despite the pandemic setback, has been predicated on a sharp reduction in costs, in part by lowering of the wage bill.

It is, therefore, no surprise that record growth in corporate profits in FY21 despite the pandemic setback, has been predicated on a sharp reduction in costs, in part by lowering of the wage bill. It is from this prism of labour market dynamics that we must view rising inflation expectations.

For India, we find evidence of causality running from CPI inflation to inflation expectations and not vice versa. Thus, it is likely that elevated household inflation expectations act as a dampener on consumption demand, especially of discretionary items, as rational households perceive an upward adjustment to wages difficult.

How do we envisage the current growth-inflation flux?

There is no denying the fact that growth that has suffered owing to the pandemic, would likely leave some degree of long-term scarring that will take time to heal. On the other hand, we anticipate that CPI inflation could average close to 5.9% over FY21 and FY22 owing to domestic and global supply disruptions on account of Covid amidst higher oil and commodity prices in 2021.

This is moderately higher than the average of 5.2% seen since the beginning of the flexible inflation targeting regime but lower than the 10-year average of 6.6%. Hence, it would be incorrect and harsh to say that high inflation is entrenched.

Covid has amplified market power with large corporations gaining market share at the cost of small firms.

The current moderate hump in inflation could turn out to be transitory as supply disruptions ease domestically as well as globally. (Implicitly we assume no runaway rally i.e., shock in global crude price). Having said so, swift progress on vaccination may trigger demand-pull inflation. In terms of timeline, this is likely to take shape in Q3 FY22, coinciding with ~60% of the population likely to get inoculated with a single dose by then.

Newer dynamics in a post-Covid economy

Demand-pull inflation can become more pronounced for two reasons premised on a temporary break-down of free-market forces –

• Rise of market power

There is global evidence of rising market power leading to higher markups. Given that Covid has amplified market power with large corporations gaining market share at the cost of small firms, it could lead to a more material passthrough of input costs to consumers in a bid to maintain high-profit margins, when demand revives.

• Import substitution to build domestic capabilities

The well-intended policy of ‘Atmanirbharta’ to establish India as being self-reliant in areas of core competencies may have an unintended consequence of short-term upward adjustment in prices, till a material increase in domestic production kicks in. Some reorientation of global supply chains could also have a role to play along with the expectation of a weaker Rupee as major global central banks led by the Federal Reserve set the ball rolling perhaps by mid2022 on bond purchase taper.

RBI will have to attend to higher inflation perhaps sooner than later.

Amidst such dynamics, the RBI will have to attend to higher inflation perhaps sooner than later. We believe that normalisation of monetary policy will remain on course as expected – beginning in Dec-21 with the restoration of the width of the LAF corridor to 25 bps from 65 bps currently (i.e, a hike in reverse repo by 40 bps) followed by an eventual 25 bps hike in the policy repo rate in Q1 FY23.

Thus, the baton of restoring potential output will have to be passed on to the Government. Since we are recovering from a negative aggregate supply shock, the policy response needs to be one that reverses the impact of this shock. In this context, swift execution of structural supply augmenting reforms like the PLI (Production Linked Incentive) Scheme under the Atmanirbhar Bharat Abhiyan will help lower inflationary pressures while creating new avenues of growth and in turn employment.

While stagflation is not a near term worry for policymakers, policy focus should continue to remain on supporting the revival of growth drivers since the damage to growth-inflation balance is skewed towards growth.

Also Read: CPI inflation: Is it transitory or here to stay

(Yuvika Singhal is an economist at QuantEco Research. Vivek Kumar is an economist at QuantEco Research. Shubhada Rao is the founder of QuantEco Research.)

(Disclaimer: The views expressed in the article above are those of the author’s and do not necessarily represent or reflect the views of Autofintechs.com. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.)

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