Relevance: Mains: G.S paper III: Economy
Context
India’s nominal gross domestic product is growing at its slowest pace in more than four decades. Also, the inflation data for December, shows the steepest rise in consumer prices since July 2014.
If this is the onset of stagflation, then it will be very hard to beat back the blues.
In the context of inflation
The risk of economic stagnation combined with high inflation has indeed risen, though the former remains the dominant force. For the central bank to get nervous and switch prematurely to a hawkish stance would be a grave error. Even if it can’t reduce interest rates any further this year, the Reserve Bank of India should keep quantitative easing among its options for supporting the economy.
Jump in inflation to 7.35%, way above the central bank’s 2% to 6% target range, was driven by food. A vegetable shortage has been emerging for some time, and that’s now making substitutes such as eggs, milk and fish more expensive, too. With food prices increasing globally, it’s hard to predict just when the Indian situation will ease.
However, core inflation, which strips out volatile food and fuel, is more under control. It inched up to 3.75% after mobile-services firms bumped up fees and rail fares rose. Still, corporate insolvencies are pushing joblessness higher. New investment—and hiring—are muted. This will constrain wages and producers’ pricing power.
While headline inflation will eventually weaken and head toward the core rate, economists expect it to stay above 6% for 2020. That would crimp the RBI’s ability to add to last year’s five rate cuts.
The monetary authority’s support can still make a difference, but only if it alters the strategy of buying government bonds from banks.
With deposit-taking institutions sitting on excess liquidity of ₹3.2 trillion ($45 billion), pumping more cash into an overflowing pond is increasingly pointless. Lubrication is needed elsewhere, and the way to provide it will be for RBI to start buying assets from insurers, mutual funds, housing finance companies and other lenders that don’t take deposits.
Consequences
This will hit two goals. As the balance sheets of funding-constrained shadow banks become more liquid, their borrowing costs, elevated since the collapse of infrastructure financier IL&FS Group in September 2018, may start to drop meaningfully.
Once the asset-sale proceeds get deposited in the banking system, the lenders will seek to deploy these liabilities to protect profitability. The 10.4% weighted average lending rate of India’s banks in November—double the central bank’s policy rate—should ease.
Recommending Federal Reserve-style quantitative easing when inflation is above 7% sounds like a plan fraught with risk. It needn’t be.
For one thing, as the State Bank of India’s chief economist, Soumya Kanti Ghosh, has been arguing, the 46% weight of food in India’s inflation basket is hopelessly outdated. If actual spending on food and beverage is closer to the 30% level reported in national accounts, inflation is being overstated by as much as 2 percentage points.
Key terms explained
Quantitative easing:
Definition: Quantitative easing is an occasionally used monetary policy, which is adopted by the government to increase money supply in the economy in order to further increase lending by commercial banks and spending by consumers. The central bank (Read: The Reserve Bank of India) infuses a pre-determined quantity of money into the economy by buying financial assets from commercial banks and private entities. This leads to an increase in banks’ reserves.
Description: Quantitative easing is aimed at maintaining price levels, or inflation. However, these policies can backfire heavily, leading to very high levels of inflation. In case commercial banks fail to lend excess reserves, it may lead to an unbalance in the money market.
Economic stagnation: Stagnation is a prolonged period of little or no growth in an economy. Economic growth of less than 2 to 3% annually is considered stagnation, and it is highlighted by periods of high unemployment and involuntary part-time employment. Stagnation can occur on a macroeconomic scale or a smaller scale in specific industries or companies. Stagnation can occur as a temporary condition, such as a growth recession or temporary economic shock, or as part of a long-term structural condition of the economy.
Headline inflation:
Headline Inflation is the measure of total inflation within an economy. It includes price rise in food, fuel and all other commodities.
The inflation rate expressed in Wholesale Price Index (WPI) usually denotes the headline inflation. Though Consumer Price Index (CPI) values are often higher, WPI values traditionally make headlines
Core Inflation (Underline Inflation or Non-food Inflation)
Core inflation is also a term used to denote the extend of inflation in an economy. But Core inflation does not consider the inflation in food and fuel. This is a concept derived from headline inflation. There is no index for direct measurement of core inflation and now it is measured by excluding food and fuel items from Wholesale Price Index (WPI) or Consumer Price Index (CPI).
