The significance of RBI mentioning the word stagflation

Stagflation was not originally part of theoretical economic discourse but a portmanteau devised during the 1960s-1970s to describe a situation of stagnant economic growth co-existing with a rising inflation rate. The situation poses dilemmas for central banks because measures to control runaway inflation usually end up further decelerating economic growth and increasing unemployment. A similar dynamic applies somewhat to India today.

While economic growth prospects remain wobbly, India has been witnessing a hardening inflationary environment over the past few months. Producer prices, reflected in the wholesale price index growth, have been rising by double-digits for some months now. This is now feeding into end-user prices, with the consumer price index rising by 7.8% in April.

The same inflationary compulsions seem to have forced RBI to further accentuate its policy pivot – from growth promotion to inflation combat – which began in April. The monetary policy for June increases the benchmark repo rate by 50 bps, taking it to 4.9% (which is still lower than the pre-pandemic level). This is the second increase in as many months, with the first rate hike of 40 bps coming in an off-cycle policy meeting convened in the first week of May.

The central bank has also decided to change its stance. The latest policy statement remains “focused on withdrawal of accommodation to ensure that inflation remains within the target going forward, while supporting growth". This is substantially different from the May stand of remaining “accommodative while focusing on withdrawal of accommodation". Translation: the word “accommodative" no longer finds favour and the central bank will continue draining excess liquidity from the system till the weighted average call rate comes closer to – or moves higher than – the repo rate, as per the central bank’s revised liquidity framework, introduced in January 2020.

The central bank has drained out liquidity close to ₹3 lakh crore over the past 12 months, primarily through the instrument of variable rate reverse repos (VRRRs). It is likely that another ₹2-2.5 lakh crore will be absorbed before the central bank is anywhere close to achieving its “neutral" rate, or the rate of interest which is neither accommodative nor inhibits growth. The instrument of choice could be VRRRs, open market operations or even an increase in the cash reserve ratio.

There is another significant lens through which to view the current monetary policy statement: given the flux in global economic conditions, it might be prudent to determine RBI’s future actions on the basis of the near quarter projections. For example, the 90-bps increase in benchmark rates in 30 days should probably be viewed against RBI’s Q1FY23 forecasts for consumer price inflation at 7.5% and gross domestic product (GDP) growth at 16.2%. Thereafter, both inflation and GDP growth projections taper off; but, this is a dynamic situation, and warrants closer monitoring and scrutiny. The central bank’s future actions will be based on the emerging situation.

It is this instability and uncertainty in the global economy that exacerbates the apprehensions of stagflation. The first mention of stagflation enveloping the global economy, including emerging markets, appeared in the RBI’s annual report for 2021-22, which was released about 10 days ago: “Policy trade-offs are becoming increasingly complex going forward and tail risks, including stagflation, loom large in several countries."

This foreboding of stagflationary pressures is also echoed in the World Bank’s latest Global Economic Prospects report. In his foreword, World Bank Group president David Malpass doesn’t pull his punches, especially on how poorer countries are likely to be hit the hardest: “Several years of above-average inflation and below-average growth are now likely, with potentially destabilizing consequences for low- and middle-income economies. It’s a phenomenon—stagflation—that the world has not seen since the 1970s." The circle is completed with both the latest monetary policy statement, as well as the RBI governor Shaktikanta Das’s statement, raising concerns over stagflation.

In the growth-inflation dynamic, RBI’s actions are now firmly rooted in managing inflationary expectations. This immediately puts a question mark over the prospects for India’s GDP, though RBI has persisted with its 7.2% GDP growth projections for FY23. Incidentally, a large component of the price rise is expected to emanate from elevated food prices. This will also require some deft supply management by the government.

This leads to the emergence of a new, post-pandemic dynamic: government versus central bank. In the policy document, the inflation forecast is higher than the 6% upper bound in almost all quarters. The RBI Act is clear that if the inflation rate remains higher than the upper bound for three consecutive quarters, it will precipitate some government action. The RBI has to submit a report, outlining the reasons for inflation spiking and provide some suggestions for remedial action. The question is: Will it single out government action as the primary reason, or will it pin the blame on globalization of inflation? This space needs to be watched carefully.