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Risk of stagflation in India lowers further, say RBI officials

Context-   Reserve Bank of India (RBI) officials have assessed the risk of stagflation in India to be 1%, which is lower than the 3% reported in August. The assessment was based on two approaches. The first approach assessed stagflation risk based on phases of lower economic growth coinciding with high inflation. The second approach used the ‘at-risk’ frameworks i.e., “Inflation at Risk” (IaR) and “Growth at Risk” (GaR) by employing quantile regression to assess the likelihood of stagflation.

  • The officials Deba Prasad Rath, Silu Muduli and Himani Shekhar wrote in the latest edition of the RBI Bulletin that “Based on data spanning from Q1:1996-97 to Q2:2023-24, empirical findings suggest that supply-side shocks such as spikes in commodity prices coupled with tighter financial conditions and relatively higher depreciation of the domestic currency turn out to be the major determinants of stagflation risk in India.”
  • It is important to note that the views expressed in the Bulletin are of the authors and do not represent the views of the RB
  • The Reserve Bank of India (RBI) officials have used two approaches to assess the risk of stagflation in India. The first approach assessed stagflation risk based on phases of lower economic growth coinciding with high inflation.
  • The second approach used the ‘at-risk’ frameworks i.e., “Inflation at Risk” (IaR) and “Growth at Risk” (GaR) by employing quantile regression to assess the likelihood of stagflation .
  • According to the officials Deba Prasad Rath, Silu Muduli and Himani Shekhar, “Based on data spanning from Q1:1996-97 to Q2:2023-24, empirical findings suggest that supply-side shocks such as spikes in commodity prices coupled with tighter financial conditions and relatively higher depreciation of the domestic currency turn out to be the major determinants of stagflation risk in India” .
  • The RBI has stated that the views expressed in the Bulletin are of the authors and do not represent its views . The officials have also mentioned that elevated risks of stagflation were experienced during specific episodes like the Asian Crisis, the Global Financial Crisis, the taper tantrum, and the COVID-19 pandemic.
  • However, latest estimates, incorporating data up to Q2:2023-24, assign a very low probability of only 1% to the risk of stagflation . In August, the RBI officials had stated that stagflation risk for India was with a probability of 3% with easing of financial conditions, stability of INR/USD exchange rate and steady domestic fuel prices .
  • Stagflation has the potential to destabilize the entire macroeconomic framework of an economy by creating an environment of uncertainty.
  • It is a major concern for the RBI as it is entrusted with the primary objective of maintaining price stability while keeping in mind the objective of growth requiring constant monitoring of any arising stagflation risk .
  • The authors of the paper observed that the appreciation of the U.S. dollar and higher commodity prices post-pandemic raised concerns of stagflation globally. The delays in the monetary-normalisation process after the pandemic also raised concerns about the potential for a costly stagflation .
  • The paper identifies two significant risk factors for stagflation in India, namely financial conditions and depreciation of the rupee against the U.S. dollar. These factors prominently influenced the likelihood of stagflation as corroborated by the empirical estimates .
  • The authors further state that similar results after using the integrated IaR and GaR frameworks to evaluate the stagflation risks adds further credence to their findings.
  • However, given the weak pass-through of crude oil prices to domestic petrol and diesel prices, it has limited predictive power for stagflation. The authors hold that compared to the historical episodes, stagflation risk is currently lower at about 1% which could be attributable to several factors.
  • Commodity price shocks are not as severe and persistent as they were back then .
  • Moreover, given the focus of central banks on maintaining price stability worldwide and healthier financial positions of financial institutions, the long-term inflation expectations have largely remained well-anchored to the inflation target unlike during the 1970s when inflation expectations were weakly-anchored and went to exorbitantly high levels .
  • The authors highlight that various factors such as the COVID-19 pandemic, geopolitical tensions, lockdowns in China, and supply chain disruptions, had contributed to this situation.
  • However, they state that compared with the stagflationary period of the 1970s, currently the risk of stagflation is lower attributing to favourable macroeconomic conditions .
  • The authors of the paper stated that recent improvements such as eased financial conditions, moderate domestic currency depreciation and stable crude oil prices have helped reduce the risk of stagflation in India .
  • The paper also highlights that India experienced a higher risk of stagflation during global financial crises, the taper tantrum, and the COVID-19 pandemic. It witnessed an economic slowdown in several phases; however, it witnessed inflationary pressures for a prolonged period during the Global Financial Crisis (2007-08) .
  • The authors suggest that a tight domestic monetary policy and sluggish global growth might have led to the economic slowdown in 2011. The uncertainty and capital outflows resulting from the taper tantrum in 2013 also impacted India’s economic growth momentum .

Conclusion- According to the Reserve Bank of India, CPI inflation was above 10% in a few months which, together with weak growth, led to a stagflationary situation . The emergence of the COVID-19 pandemic and elevated inflation in 2020, although for a short period, raised the risk of stagflation. However, the stagflation risk arising post COVID-19 had subsided reflecting easing of financial conditions, contained depreciation of the INR/USD exchange rate and stable domestic petrol and diesel prices .

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