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Home / Opinion / Columns /  India faces a new worldwide dragon: Stagflation 2.0

Reports from multilateral financial institutions, newsletters from hedge funds, central bank documents, news bulletins and social media reports are all pulsating with a single word: stagflation. The question that everybody’s asking: is this 1970s redux, when stagflation first reared its head? And, what does it mean for India, even though both the government and Reserve Bank of India (RBI) have been trying to downplay its effects?

The term ‘stagflation’ was a neologism coined in the 1960s to describe a peculiar economic condition—slow growth, a high inflation rate, high unemployment and an output gap—and it now occupies a permanent place in serious economic discourse. The 1970s saw the global economy, led by the US economy, experience its first bout of stagflation. There were later episodes as well, but nothing as bad; the 1970s run lasted for over a decade. Closer home, the curiosity about what stagflation overseas may mean for the Indian economy is framed by our own travails of slow growth, high unemployment and rising prices.

Before we get there, it might be instructive to compare the current situation with the 1970s. Here’s a checklist.

Are oil prices as high as they were in the 1970s to propel commodity-led inflation? Check. A geopolitical stalemate has led to the oil crisis of the 1970s and the Russia-Ukraine war has pushed oil prices to a record high this time. Was there a liquidity overhang then as now? Absolutely. Central banks during the 1970s followed an expansionary policy because the theoretical framework in use was different then. Cut to the present, and excess liquidity—the pandemic having forced governments and central banks to turn on liquidity taps—is another big factor contributing to inflationary impulses.

But, despite these similarities, the precise reasons for inflation this time are difficult to disentangle. While economists are still busy trying to quantify the exact contribution of different factors to the current inflationary episode, three primary reasons stand out: a demand spike due to fiscal and monetary stimuli in most countries, a supply shock following a breakdown in key logistics networks, and a decisive blow to commodity price stability, especially in food and oil, imparted by the Russia-Ukraine conflict, which has set off an inflationary spiral.

Move to growth and employment and the similarities with the 1970s episode begin to diverge. Most economies are still logging growth on the back of continued fiscal support and lagged monetary policy normalization. The policy statement of the US Federal Reserve, which increased its benchmark rate by 75 basis points (bps) on 15 June, read: “Overall economic activity appears to have picked up after edging down in the first quarter. Job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures." In its latest State of the Economy report, Reserve Bank of India (RBI) staffers noted: “Gross domestic product (GDP) for 2021-22 surpassed its pre-pandemic (2019-20) level by 1.5 per cent and activity is gaining strength in 2022-23 so far as gauged from high frequency indicators."

There is another disturbing factor that is common to both eras and might be key to understanding some of the ripple effects for the Indian economy: the cumulative debt owed by the state, corporate sector and households was high then and is perilously high even now. While researchers are still trying to decode the current situation, with some variables meeting stagflation preconditions and not others, the implications for India are clear in the short and medium terms.

In the US, for example, with real interest rates still in negative territory and demand yet to be reined in, the Fed will have to keep hiking nominal interest rates for a while till it can dampen inflationary fires. Sample the Fed’s resolution: “The Committee is strongly committed to returning inflation to its 2 percent objective". Economists and bond traders are trying to figure out how much higher the Fed can take nominal interest rates, because, beyond a tipping point, higher rates can have serious repercussions on a wide variety of indebted economic agents. Many leveraged positions will turn sour, the financial value of collaterals will erode, bank balance sheets will start crumbling, a financial crisis will build up, and the Fed might have to ride to the rescue of some banks. A crisis like that would travel across the oceans through multiple channels.

India faces serious financial instability risks as the Fed continues its rapid-fire tightening, or even prolongs its current policy normalization process. One outcome of higher dollar interest rates could be diminished asset prices in the US, which will automatically lead to capital outflows from India and create attendant pressure on the rupee. A higher dollar interest rate and weaker rupee has implications for India’s foreign debt, which was $615 billion at the end of December 2021. It also jeopardizes future foreign currency borrowings. Given India’s reliance on capital flows and the spectre of a widening current account deficit, all this poses serious concerns for the country’s macro-economic stability.

The latitude available for RBI’s policy choices then shrinks automatically, forcing a shift from pursuit of economic growth to single-minded inflation targeting.

Rajrishi Singhal is a policy consultant and journalist. His Twitter handle is @rajrishisinghal.

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