Slate

All you wanted to know about Stagflation

Hari Vishwanath | Updated on May 31, 2021

In India we have hardly had any periods without inflation, while developed markets besides inflation, also experience deflation occasionally. But it’s been decades since we saw any of the major economies experience stagflation; a potential threat that exists now according to some economists, due to the money printing in developed economies even as global growth is sluggish.

What is it?

Stagflation is an economic situation where slow economic growth or stagnation, or even recession, coexists with high inflation. Normally periods of high economic growth are characterised by price rise. Economic growth drives incomes of corporates and employees which in turn results in more demand for goods and services. This leads to inflation and becomes a reinforcing loop. The reverse plays out during periods of recession, which is usually accompanied by deflation. But stagflation is a situation where incomes shrink and yet prices rise. The US and UK experienced stagflation in the 1970s.

Why is it important?

In a world that has become addicted to easy monetary policy as the panacea to all economic ills, stagflation would be like blocking the jugular vein. The aim of easy monetary policy is to stimulate the economy by stoking demand. But if slow economic growth is accompanied by price rise, this is a challenge that cannot be addressed by cutting interest rates and quantitative easing and money printing. That would be like adding fuel to fire.

Stagflation in the US in 1970s was attributed to three factors — the oil supply shock, poor policy decisions by the Nixon government like high import tariffs and removal of the gold standard, and accommodative monetary policy.

Even in India monetary policy has been accommodative with low rates to help deal with Covid’s economic fallout. The RBI has added to this accommodative stance with liquidity pumping measures like open market operations and special windows for distressed sectors. At the same time, it has also warned in its 2020-21 annual report that inflation remains a key risk. While stagflation may appear unlikely in India, plans to address it in case it materialises must be given due consideration.

Why should I care?

If growth does not keep trending up over the next few years, then stagflation could be a likely scenario . In the US, the Fed balance sheet has doubled to nearly $8 trillion in 18 months. This apart, the world is also going through supply shocks driven by delayed supply responses in some commodities and shortages of key components like semi-conductor chips in key industries. Tariff wars and protectionism — policy decisions that are inflationary, have also been in play in the last couple of years. Connecting these dots, we may very well have in place all of the three main factors that caused the 1970’s stagflation — supply shocks, government policy decisions and ultra-accommodative monetary policies. As of now though, supply shocks and government policy are less pronounced than ultra-accommodative monetary policy.

The pain of economic stagnation, high inflation and high unemployment in the US due to stagflation was ended by the ‘Volcker shock’. US Fed Governor Paul Volcker bit the bullet and took the politically difficult decision of sharply increasing the Fed rate to fight inflation. This solved stagflation, but only after causing a recession in 1981.

The bottomline

Stagflation is not hitting the world or India tomorrow. But the excessive money printing over the last one year taking with emerging evidence of inflation, can result in the dreaded stagflation. We should not be dismissive of it.

A weekly column that puts fun into learning

Published on May 31, 2021

Follow us on Telegram, Facebook, Twitter, Instagram, YouTube and Linkedin. You can also download our Android App or IOS App.

This article is closed for comments.
Please Email the Editor

You May Also Like