Are we heading for stagflation?

IN PERSPECTIVE

When it meets early next month, the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) will be faced with a dilemma in a situation of declining economic growth rate coexisting with rising consumer price index (CPI): to cut the interest rate or not, that will be the question. Retail inflation is now at a 16-month high of 4.62%, which is well above the RBI’s target rate of 4%.

The Indian economy is in the doldrums. The downward trend began, after fast growth until the second quarter (Q2) of FY2017, with demonetization. The resultant cash shortage halted economic activities and growth rate declined to 7.5% in Q3 and 7% in Q4 of FY17. The introduction of GST eight months later brought its own woes. The growth rate sank to 6% in Q1 FY2018. Worldwide uncertainties consequent to US-China trade war in late 2018 engulfed the world. The Indian economy grew at a slower pace: 7% in Q2, 6.6% in Q3 and 5.8% in Q4 of FY19. In the latest quarter, Q1 of FY2020, it grew only 5%.

Mounting bad loans of the public sector banks (PSBs), and frauds and scams with culprits absconding and escaping punishment due to poor handling by investigating agencies, have also reduced consumer and producer confidence. We also had the failure of some leading non-banking financial institutions, resulting in reduced credit flows for financing economic activities, domestic investment and consumption.

The fall in household incomes in rural and urban India and financial stress have reduced consumption of even necessities such as toothpaste and biscuits, and demand for durable goods and cars and two-wheelers. The fall in domestic demand appears to be the main cause behind falling growth.

The State Bank of India says growth would fall further in Q2 (July-Sept), FY2020. The forecast is based on the poor show in industrial production, which would be less than the 2.7% in Q1, FY20. The official figures are expected on November 29.

To revive the sagging economy, expansionary fiscal policy measures have been initiated. In September, the government cut the corporate tax rate to 22% from 30%. For new manufacturing companies, it would be 15%. As part of expenditure policies, the government decided to recapitalize PSBs and merge 10 PSBs into four. Further, it decided to support the automobile sector and prepare plans for infrastructure spending.

Fiscal policy tools are always blunt. They take time to yield tangible results. So, the RBI decided to make the borrowing cost cheaper to boost investment in durables, including housing, and encourage consumption of semi-durables, including automobiles and appliances. Over the past 11 months, the RBI has been on a rate-cutting spree, reducing the policy rate by 135 basis points from 6.5% to 5.15% by October. With the economic outlook growing more pessimistic, a further rate cut in December looked certain until last week.

Now, there are new concerns for the RBI. The disturbing news is that consumer inflation shot up to 4.62% in October, exceeding the 4% target rate. It was the highest in 12 months, rising from the September rate of 3.99%. The culprits are the volatile, food-related items: vegetables and fruits, while imported petroleum crude price has been low. If it also rises, it will be another story of misery. Facing high retail inflation, any decision to cut the interest rate on December 5 would be inappropriate. The RBI would be accused of not following its mandate.

The only comforting point in favour of a rate cut is that core inflation (which is measured leaving aside food and fuel inflation) is not only low, but actually in the negative: minus 0.84%. The CPI rose in October mainly because of food prices rising by 7.89% as compared to 5.11% in September. On the other hand, the wholesale price index (WPI), comprising final manufactured goods, rose only by 0.16%. Thus, the final and processed agricultural and food products included in WPI are responsible for WPI inflation.

That brings us to the good old debate whether the 2013 decision to switch to CPI from WPI as the target right for RBI is the correct approach for measuring inflation and taking monetary policy decisions. So, with inflation at 4.62%, along with stagnation, the dilemma facing the MPC members is clear.

The latest Reuters report says China is facing a similar situation, with the strongest inflation in eight years. With surging imported pork prices due to switching on to safer sources away from countries affected by African Swine Fever, China’s consumer inflation has gone up. It exceeded the target rate of 3% in October. China’s economic growth is now at its slowest in nearly three decades due to the global slowdown and the trade war with the US. It is being hotly debated whether China should raise the interest rate to fight inflation or cut interest rate to boost economic growth.

Are we now heading for another episode of global stagflation as well?

(The writer is a Visiting Honorary Adjunct Professor, Amrita School of Business, Bengaluru Campus)