Reserve Bank of India (RBI) officials believe the risk of stagflation — a portmanteau of economic stagnation with high inflation — has lowered further to 1% compared with 3% in August based on available data, using two approaches.
In the first approach, stagflation risk was assessed 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.
“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,” wrote the officials Deba Prasad Rath, Silu Muduli and Himani Shekhar in the latest edition of the RBI Bulletin.
The RBI said that the views expressed in the Bulletin are of the authors and do not represent its views.
“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. Latest estimates, incorporating data up to Q2:2023-24, however, assign a very low probability of only 1% to the risk of stagflation,” they said in the chapter ‘Low’ Stagflation Risk in India.
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.
Stating that stagflation had the potential to destabilise the entire macroeconomic framework of an economy by creating an environment of uncertainty, they said it was a major concern for the RBI as it was 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.
Further, higher commodity prices and the appreciation of the U.S. dollar post-pandemic raised concerns of stagflation globally. The delays in the monetary-normalisation process after the pandemic have also raised concerns about the potential for a costly stagflation, they observed.
Identifying two significant risk factors for stagflation in India namely financial conditions and depreciation of the rupee against the U.S. dollar, they said these factors prominently influenced the likelihood of stagflation as corroborated by the empirical estimates.
“Similar results after using the integrated IaR and GaR frameworks to evaluate the stagflation risks adds further credence to our findings. However, given the weak pass-through of crude oil prices to domestic petrol and diesel prices, it has limited predictive power for stagflation,” they held.
“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,” they stated.
“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,” they added.
Highlighting that various factors such as the COVID-19 pandemic, geopolitical tensions, lockdowns in China, and supply chain disruptions, had contributed to this situation, they however said compared with the stagflationary period of the 1970s, currently the risk of stagflation was lower attributing to favourable macroeconomic conditions.
Encouragingly, the estimated results indicate 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, they stated.
Data over the past two decades indicate 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), they said.
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.
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, they stated.
They opined that 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.