India Struggles to Avoid Curse of Stagflation

As India continues to struggle with high inflation even as the economy slows, some worry it could be sliding toward a painful period of stagflation. The dreaded S-word was coined around 50 years ago to describe an economic rut of stagnation and inflation where weak demand hurts growth but doesnt rein in prices. While the Indian economy is far from stagnant, recent data have been discouraging. The economy might be trapped in a stagflationary-type environment, as growth is at the cusp of moving another leg lower while inflation bottoms out, says Radhika Rao, a Singapore-based economist with DBS Bank. Data Monday showed Indias wholesale inflation hit a six-month high of 6.1% in August as food and fuel prices soared. Consumer inflation already has been hovering near double-digit levels for months and was at 9.52% in August, the government reported last week. Economists expect inflation to fall later this year as favorable monsoon rains help lower food prices, but some say inflation could stick at unusually high levels as the weaker rupee boosts the local price of imports.

Inflation is often the result of an overheating economy, but Indias economy has been cooling in recent years. Investors have grown increasingly wary of the slow pace of change in economic policies to facilitate business. Shabby infrastructure potholed roads, overcrowded ports and airports and a perennial national power shortage places further hurdles in the way of expansion. Infrastructure bottlenecks make it more expensive to produce and deliver goods, adding to inflation. Indias gross domestic product grew just 4.4% in the quarter to June. That was its weakest expansion in more than four years and less than half of the 9+% growth the economy recorded in the fiscal year ending in March 2011. Last years 5% GDP growth was the worst in over a decade. Indian industry has been struggling due to weakening demand both locally and overseas. A sharp rise in borrowing costs as the central bank battles inflation has aggravated industrys problems. Data last week showed industrial output grew just 2.6% in July and has contracted in two of the four months since April, after growing just 1.1% in the fiscal year ended in March. The automobile industry, a key driver of manufacturing growth and an indicator of the wider health of Indias economy, has been feeling the slowdown. The Society of Indian Automobile Manufacturers last week forecast that auto sales would fall for a second straight year. Not all the news is bad: Exports grew about 12% in July and 13% in August on stronger global demand and as the weak rupee makes Indian exports more competitive. At the same time, the weak currency makes imports into India more expensive, helping to narrow the countrys trade deficit. Optimists hope government moves over the past year to encourage more confidence in the economy such as easing foreign investment restrictions and speeding up government approvals for industrial projects will start to show some results. To nudge things toward recovery, the government needs to implement more confidence-building reforms. Deepening the shallow corporate bond market could facilitate financing for infrastructure and industrial development. Elevated inflation may prevent the Reserve Bank of India from lowering interest rates at Fridays meeting but it could find other ways to boost bank lending, such as reducing the portion of deposits banks must park in liquid assets such as government bonds or gold. For the time being, Indians may have to endure a slowdown even as prices rise. But optimists are hopeful it can avoid a long period of stagflation.
June 2, 2013:

The defining characteristic of the Indian economy now is its slide into stagflation the combination of sliding aggregate economic activity (measured by GDP) and high and stubborn inflation. Stagflation is probably the most difficult problem for economic policymakers to tackle. Globally, the best example of how a country tackled and cured stagflation is available from the US experience of 1979 to 1982. Like in India now, US GDP growth was first volatile and then decelerated sharply while consumer inflation rose to double-digits through the course of the 1970s.
Liquidity tightening

The policy medicine involved the central bank (Federal Reserve under Chairman Paul Volcker) creating extreme financial liquidity tightness and pushing interest rates up sharply. The administration of that monetary medicine for some three years worked, and the US then embarked on a stable, relatively high economic growth path for the next two decades that period of stable, robust growth with low inflation was interrupted only by the dotcom crash of 2000 and the relatively mild recession it caused. With a good monetary policy framework in place, the stock market crash of 2000 caused only a mild recession. Also, the 1997 turbulence in the financial markets (Asian/Russian financial crisis) caused only a brief scare.
Pain unavoidable

The US experience shows that near term economic pain may be unavoidable to sustain-ably cure stagflation. Absent such action, economies are likely to function in a sub-par manner and bounce along in a volatile manner with significant levels of imbalances/disequilibria. In India, the Reserve Bank of India is nowhere near attempting what the US Fed did in the 19791982 period. (It is interesting to note that prior to 1979, the US Fed also advanced the same arguments the RBI has been making in recent years, washing its hands off inflation containment note the hair-splitting about core and non-core inflation, supply-side causes, weak monetary policy transmission, and so on). This reluctance to act poses the greatest threat to Indias medium term economic growth prospects as it endangers financial system stability.

Weak real economic activity but high consumer inflation means that financial institutions will face problems on both their asset and liability sides. Asset quality will be weak and asset growth volatile with no relief on the funding side too. Clear evidence of this unbalanced operating environment for financial services businesses has been available in the past few years.
CPI bugbear

Though inflation measured by wholesale prices has declined in recent months, consumer price inflation continues to be in double-digits and households inflation expectations are also wellentrenched in the double-digits range. As financial institutions render services to the retail market, it is only consumer price inflation which retail households face on a day-to-day basis which is the relevant inflation measure for assessing the impact of inflation on the financial services business. That consumer price is the inflation measure most relevant for financial institutions is also borne out sharply by the sustained deceleration in the deposit growth of the banking system in the past few years. With the rates on offer way below the level of prevailing consumer inflation, the pace of banks deposit accretion has been steadily declining. That deceleration has resulted in an overall wedge developing at the systemic level between deposits and credit growth of some five percentage points. The longer this gap is not closed, greater the chances of disorderly corrections coming about in the broader economy. This structural funding gap has been continuously in the past several years made up by large daily borrowings from the Reserve Bank of India. By providing large liquidity support to the banking system on a daily basis, the RBI is preventing banks deposit rates from reacting to the funding deficiencies in the only manner they should going up. The RBI therefore accentuates the underlying problem which is that rates on deposits are out of line with the underlying retail inflation pressures and consequently deposits growth in the banking system is sliding. The continuation of this trend poses the biggest threat to financial system stability. If the weaknesses in banks balance-sheets are addressed in time, the system as a whole may be able to avoid a forced and sharp ratcheting up of interest rates.

The longer it is postponed, greater the likelihood of disorderly corrections in the financial markets stocks, currency and bonds and sub-par performance of the broader economy. (The author is a Chennai-based financial consultant.)
(This article was published on June 2, 2013)

Keywords: Stagflation in India, RBI, monetary policy, Federal Reserve under Chairman Paul Volcker, consumer price inflation, Indian economy

Stagflation, 1970s Style

May 31 2009| Filed Under Ben Bernanke, Federal Reserve, GDP, Inflation, John Maynard Keynes, Macroeconomics, Milton Friedman, Monetary Policy, Paul Volcker, Powerful Leader Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believed that inflation was tolerable because it meant the economy was growing and unemployment would be low. Their general belief was that an increase in the demand for goods would drive up prices, which in turn would encourage firms to expand and hire additional employees. This would then create additional demand throughout the economy. According to this theory, if the economy slowed, unemployment would rise, but inflation would fall. Therefore, to promote economic growth, a country's central bank could increase the money supply to drive up demand and prices without being terribly concerned about inflation. According to this theory, the growth in money supply would increase employment and promote economic growth. These beliefs were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes. (For related reading, see Understanding Supply-Side Economics.) In the 1970s, Keynesian economists had to reconsider their beliefs as the U.S. and other industrialized countries entered a period of stagflation. Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation. In this article, we'll examine 1970s stagflation in the U.S., analyze the Federal Reserve's monetary policy (which exacerbated the problem) and discuss the reversal in monetary policy as prescribed by Milton Friedman, which eventually brought the U.S. out of the stagflation cycle. (For more on Friedman's economics, see Monetarism: Printing Money To Curb Inflation.) 1970s Economy When people think of the U.S. economy in the 1970s the following comes to mind:

High oil prices Inflation Unemployment Recession

Indeed, the average price of a barrel of oil reached a peak of $104.06 (as measured in 2007 dollars) in December of 1979. (Want to read more about how inflation affects the value of your dollar in the future? Read our tutorial, All About Inflation.) Figure 1 shows a history of oil prices as measured in 2007 dollars.
Day Trade Stocks with $500

Figure 1 Source: InflationData.com as of 1/16/2008 Inflation was also high by U.S. historical standards. Figure 2 shows year-over-year percentage changes in the core Consumer Price Index (CPI) (the CPI less food and energy expenditures).

Figure 2 Source: Bureau of Labor Statistics In the 1970s, there was a two-year period of economic contraction as measured by gross domestic product (GDP) in year 2000 dollars (i.e. Real GDP): 1974 GDP contracted 0.5%, and in 1975, GDP contracted 0.2% and unemployment reached 8.5%. In 1980, GDP contracted 0.2%. (To learn more, read The Importance Of Inflation And GDP.) The prevailing belief as promulgated by the media has been that high levels of inflation were the result of an oil supply shock and the resulting increase in the price of gasoline, which drove the prices of everything else higher. This is known as cost push inflation. According to the Keynesian economic theories prevalent at the time, inflation should have had an inverse relationship with unemployment, and a positive relationship with economic growth. Rising oil prices should have contributed to economic growth. In reality, the 1970s was an era of rising prices and rising unemployment; the periods of poor economic growth could all be explained as the result of the cost push inflation of high oil prices, but it was unexplainable according to Keynesian economic theory. (For more, see Cost-Push Inflation Versus Demand-Pull Inflation.) A now well-founded principle of economics is that excess liquidity in the money supply can lead to price inflation; monetary policy was expansive during the 1970s, which could explain the rampant inflation at the time. Inflation: Monetary Phenomenon Milton Friedman was an American economist who won a Nobel Prize in 1976 for his work on consumption, monetary history and theory, and for his demonstration of the complexity of stabilization policy. In a 2003 speech, the chairman of the Federal Reserve, Ben Bernanke, said, "Friedman's monetary framework has been so influential that in its broad outlines at least, it has nearly become identical with modern monetary theory His thinking has so permeated modern macroeconomics that the worst pitfall in reading him today is to fail to appreciate the originality

and even revolutionary character of his ideas in relation to the dominant views at the time that he formulated them." Milton Friedman did not believe in cost push inflation. He believed that "inflation is always and everywhere a monetary phenomenon." In other words, he believed prices could not increase without an increase in the money supply. To get the economically devastating effects of inflation under control in the 1970s, the Federal Reserve should have followed a constrictive monetary policy. This finally happened in 1979 when Federal Reserve Chairman Paul Volcker put the monetarist theory into practice. This drove interest rates down to double-digit levels, reduced inflation down and sent the economy into a recession. In a 2003 speech, Ben Bernanke said about the 1970s, " the Fed's credibility as an inflation fighter was lost and inflation expectations began to rise." The Fed's loss of credibility significantly increased the cost of achieving disinflation. The severity of the 1981-82 recession, the worst of the postwar period, clearly illustrates the danger of letting inflation get out of control. This recession was so exceptionally deep precisely because of the monetary policies of the preceding 15 years, which had unanchored inflation expectations and squandered the Fed's credibility. Because inflation and inflation expectations remained stubbornly high when the Fed tightened, the impact of rising interest rates was felt primarily on output and employment rather than on prices, which continued to rise. One indication of the loss of credibility suffered by the Fed was the behavior of long-term nominal interest rates. For example, the yield on 10-year Treasuries peaked at 15.3% in September 1981 - almost two years after Volcker's Fed announced its disinflationary program in October 1979, suggesting that long-term inflation expectations were still in the double digits. Milton Friedman gave credibility back to the Federal Reserve. (For further reading, see The Federal Reserve.) Conclusion The job of a central banker is challenging to say the least. Economic theory and practice has improved greatly thanks to economists like Milton Friedman, but challenges continuously arise. As the economy evolves, monetary policy, and how it is applied, must continue to adapt to keep the economy in balance.