Battle Royale over stagflation
By Anjan Roy
C. Rangarajan, chairman of the Prime Minister’s Economic Advisory Council, is a highly respected economist in the country and what he says is taken as a last word. But the government’s new chief economic adviser, Raghuram Rajan, has chosen to disagree with him publicly.
If Rangarajan is venerated in the country, Rajan is well regarded in present-day global economists pantheon. He is credited with having sounded the warning note at a meet of US Federal Reserve at Jackson Hole just before the financial meltdown struck. The public disagreement was therefore a battle royale of sorts.
But then, what was the difference?
They differed over what is known among economists as ‘stagflation’. This is a word generally shunned by experts. Stagflation means when an economy stops growing and becomes stagnant, but at the same time faces rising prices or inflation. This is the worst combination to have and getting out of such a situation is the most difficult task for economic policy making. Let us see why, but before that let us see how the protagonists are ranged in the battle.
In a paper, Rangarajan asserted that the Indian economy had entered into a phase of stagflation in view of falling growth rate and rising prices. Rangarajan had studied, along with Alok Sheel, who is the secretary to the PMEAC, the authors examined the trends in prices and production growth over last several years.
Rajan however pointed out stagflation is a situation when prices are rising but production growth remains stagnant. With India growing at 5 per cent annually, you cannot say India is facing stagflation. In fact, given the current global situation, a growth rate of 5 per cent annually for a major economy like India is considerable. Most other countries economies are either shrinking or growing at far lower pace. Advanced economies generally are growing, if at all, by just about 2.5 per cent.
Whether India has currently entered a phase of stagflation or not has major policy implications. In theory, an economy cannot be both stagnant and have rising inflation. In a stagnant economy, demand will fall and therefore prices should fall to adjust to falling demand conditions. On the other hand, prices can start rising and become inflationary when there are no excess production capacity and demand is in excess because of growth stimulus and therefore prices rise in response to demand.
In practice, however, countries have frequently been found to be in stagflation. The problem for policy formulation in such a case is that if follow a policy for driving up growth, prices should rise and thus aggravate the inflationary pressures. On the other hand, if you try to bring down prices and achieve price stability, then such policy action should depress growth.
Although Raghuram Rajan is technically correct in saying that India was not in a stagflation since ‘the economy is growing by a decent 5 per cent’, the policy choices from the central bank’s point of view has become a dilemma one faces in a situation of stagflation.
Rangarajan, who has been the governor of the Reserve Bank for a very long time, could have referred to the monetary authority’s policy options in the current situation. Indeed, RBI has been facing this impossible choice for at least two years now and been blamed for the current drop in growth rate. It has been following a strictly monetarist approach for the last two years when prices have proved to be stubbornly on the rise.
The RBI will face the same difficult choice in formulating its monetary policy stance during the upcoming review on 19 March. Going by the latest IIP figures as well as the latest price data, it will be difficult for the RBI to formulate its position. IIP showed industrial production growing by just 2.4 per cent in January this year. Of course, IIP had shown contraction in two previous months and excepting for October last year had been languishing at very low levels or shrinking.
Leaving aside the nit-pickings over marginal variations, the industrial sector has been languishing for upwards of a year and this was a very different story from when this sector was growing at double-digit levels. The fall in industrial sector had further started depressing the services demand and therefore the services sector growth is slowing down. Overall, growth has plummeted from around 8.5 per cent annually to the present 5 per cent and possibly below.
The RBI ordinarily should have followed an expansionary monetary policy, cut down the policy interest rates and should have tried to encourage growth.
It could hardly do that as the price situation is still causing worry. The latest price inflation data, released almost at the same time as the IIP, showed wholesale inflation rate marginally rising. Worse, the retail inflation, measured by the consumer price index, showed strong price rise at nearly 11 per cent. The food inflation is even worse and onion prices have risen, going by the latest price data, by as much as 154 per cent, potato prices by 46 per cent cereals prices by 20 per cent. Fuel prices have gone up by 10.5 per cent and this has a very high weightage on overall inflation.
What should the RBI do? Should it give more emphasis on growth revival or should it further clamp down on inflation control? RBI has been criticised for trying to control food prices driven inflation by monetary policy tools, thereby achieving neither price stability nor growth. RBI has defended itself saying that anti-inflationary stance is dousing strong inflationary expectations and therefore containing inflation.
In the end, Dhuvuuri Subbarao, governor, RBI, will have to make the difficult choice, no matter whether Rangarajan is right or Raghuram Rajan. Our fates are willy-nilly ion the hands of the triad of the economic pantheon. (IPA Service)