Earlier this week on 12 October, government data showed that India's retail inflation (measured by Consumer Price Index or CPI) for the month of September was recorded at 7.34 percent. The reading is higher than the Reserve Bank of India's (RBI) target of 2%-6%.
How does RBI control inflation?
A central bank (India's central bank is RBI) takes measures to reduce the supply for cash in its economy to control inflation. If people have more cash, they spend more, which causes an increase in the price of commodities (which is what we call inflation).
Therefore to control the cash flow and a rise in commodity prices, the central bank increases interest rates it charges to banks. This interest rate is known as the repo rate. Repo rate is the rate at which RBI lends to banks in India.
Consequentially, banks also increase their interest rates, both on loans and deposits, which is when people prefer saving rather than spending; controlling cash flow in the economy.
In the opposite scenario, RBI will lower the interest rates when it wants more businesses and individuals to borrow and spend. This increases economic activity and pushes economic growth.
As per "Monetary Policy Framework Agreement" or the "Flexible Inflation Targeting (FIT)" framework, which is set every 5 years, the monetary policy committee, headed by RBI governor, decides on the inflation target. In 2016, the current inflation (CPI) target was set to be a wide band of 2%-6% with 4% as the mid-point.
The next recent is in six months, that is, in March 2021. The framework's target is to ensure price stability while keeping in mind the objective of growth.
The Indian economy saw a mix of low inflation, sticky inflation, high growth and low growth in the last four years. The positive outcome in the five year period has been that the economy did not see double-digit inflation, which was the case prior to 2014 due to high oil prices.
Some argue that the price stability may have come at the cost of a slowdown in the economy, even before COVID-19. With the GDP contraction induced by the pandemic, the economy is in a sticky situation.
As mentioned above, inflation has surpassed RBI's target, but in the current scenario where the Indian economy reported a historic contraction in GDP of 23.9 percent for the April-June period, the central bank is forced to keep rates low.
In the latest monetary policy committee meeting on 9 October, RBI left the rates unchanged at 4 percent, while retaining an "accommodative" stance - which rules out any hikes for the time being.
What is stagflation and why do economists feel it is a looming threat to the Indian economy?
In November 2019, in an opinion piece in The Hindu, former Prime Minister and renowned economist, Manmohan Singh, called the state of India's economy "deeply worrying" and warned of a further rise in retail inflation amid nominal economic growth and high inflation posing a risk of stagflation.
"Continued increase in inflation combined with stagnant demand and high unemployment will lead to what economists term as ‘stagflation', a dangerous territory from which it becomes very hard for large economies to recover. While we are currently not in stagflation territory yet, it is prudent to act quickly to restore consumption demand through fiscal policy measures since the impact of monetary policy seems muted," he wrote, back when India's GDP was growing at 5 percent.
As explained by our ex-PM, Stagflation is a combination of high inflation with high unemployment and stagnant demand. The effects of which are often felt more by the most vulnerable sections of society.
Singh's concerns were raised in November, before the outbreak of COVID-19, when the GDP growth rate was at a 15-year low on top of high unemployment, piling bad loans at banks and low consumption levels (especially in automobile sales).
In the current financial year 2020-21, the economy has faced an additional blow of an inescapable contraction in GDP due to the pandemic.
Ideally, when an economy is faced with falling output, government and the central bank would have to follow a loose fiscal policy/monetary policy to push economic activity but with the economy simultaneously dealing with high inflation levels, the central bank cannot lower interest rates as it could push prices further upwards.
The stagflation risk debate is going around among all major economies.
Role of COVID-19 and wholesale inflation
Up till July, wholesale inflation remained in the negative zone while CPI was above 6 percent. This meant there was inflationary pressure only at the retail level, and not at the wholesale level which could be attributed to the supply-side disruptions caused by COVID-19.
However, in August and September, as per data released on 14 October, WPI (wholesale inflation) rose, possibly due to heavy rains in the two months.
Further, CPI data shows that food inflation in September was above 10 percent.
First COVID-19 and now rainfall is hampering measures to control inflation levels.
Too soon to say if economy is entering stagflation
The Indian government is taking several measures to increase consumption and control food prices. Recently, the finance ministry announced an LTC scheme and interest-free loans to government employees to push big purchases. Export of onions was also banned to control prices.
While it would be too early to say if stagflation is on its way to India, with rising COVID-19 cases, unseasonal rainfalls, seasonal jobs and low economic activity, the risk is high, leaving RBI in a monetary policy conundrum.