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Clear and Present Danger: Economic Stagnation and Inflation could lead to Stagflation

Clear and Present Danger: Economic Stagnation and Inflation could lead to Stagflation

The combined effect of economic stagnation and rising inflation could lead to stagflation of the kind the world has not seen since the 1970s

Udayan Mukherjee Udayan Mukherjee

I began the year cautioning readers of this column that 2022 could be a year resembling a board of snakes and ladders, and urging them not to disregard the rising risks that stood to derail a fragile post-Covid-19 recovery. Now, with every passing week, the snakes only seem more menacing, the ladders wobbly. The twin vipers of economic stagnation and rising inflation are baring their venomous fangs, raising the spectre of a much-feared stagflation that the world has not had to countenance since the 1970s. We are not there yet, but the risks are very real.

Even at the start of the year, inflation was always going to be a problem. The financial world was prepared for a gentle withdrawal of liquidity and an ‘ever so gradual’ lifting of interest rates. But then, events conspired in a way that has left the US Federal Reserve struggling to catch up and now we are almost at panic stations. The problem with ostracising and punishing Russia for its reckless behaviour is that it happens to be the world’s largest exporter of most commodities—from energy and metals, to foodgrains and fertilisers. The result is a commodity price shock that is stoking the fire of inflation everywhere in the world, forcing central banks to turn their focus squarely on inflation, at the expense of supporting a post-Covid-19 recovery. The tricky part is that we don’t know where this path leads us, and when a problem that is a ‘known unknown’ drifts into ‘unknown unknown’ territory, inducing panic. Financial markets may have digested the first rate hike in the US and resigned themselves to around six more this year, but what if it is not six but 10? What if the Fed loses its nerve in the war against inflation? Just in case one considers these fears alarmist, former US Treasury Secretary Larry Summers is on record predicting that US interest rates will have to rise to—hold your breath—5 per cent before we are done with it. If this were to come to pass, we are staring at a major crisis, not a garden variety slowdown.

This rise in interest rates comes at an inopportune time, just as the world is beginning to find its feet post the Covid-19 disruption. To be sure, we are not even over that hump yet as the recent data from China suggests. The Covid-19 shutdowns there are a reminder that the world is still swimming with weights tied around its ankles, and any future waves could crimp progress further. China’s reluctance to unleash major stimulus packages, unlike in previous episodes of a slowdown, tells us that it is orchestrating a transition to lower mid-term growth, a shift that robs the world of a sorely needed catalyst. If the US is to reel under rapidly rising interest rates, with Europe hamstrung by high energy prices and supply disruptions, and China adopting such a cautious stance, what will drive global economic growth?

Flanking these two major risks are attendant problems such as the prospect of de-globalisation. This is already underway and poses serious risks of supply chain disruptions and even currency skirmishes if the economic situation worsens. New alliances are being forged between the big global players, hard stances adopted, and the dollar’s preeminence challenged.

India seems to be in a relatively better place, but it would be foolish to be complacent as we can never be immune to the world’s problems. Rising energy prices are already beginning to pinch, and the latest Consumer Price Inflation (CPI) print of 6.95 per cent in March is a warning that the RBI may already have fallen behind the curve. Soon, it won’t have much choice but to prioritise inflation over growth. Inflation expectations are already getting entrenched with consumers and this will inevitably lead to curtailing of discretionary consumption, possibly leading to lower-than-expected growth, and earnings for many companies. Indian macro, which looked rock solid even a few months ago, is beginning to show some cracks. The less said of global macro, the better.

More than anything else, what all this does is create an air of great uncertainty—an environment that suffocates risk taking. After many years, Indian companies were on the brink of embarking on capacity expansion, nudging our investment-to-GDP ratio higher. As commodity prices rise, some metal companies and upstream energy players may consider it attractive to commission new projects, but the rest of the pack may—deterred by the prospect of shrinking margins, declining demand and general global uncertainty—easily go into a shell. This would dash hopes of a new capex cycle, so critical for accelerating our medium-term growth trajectory.

It is always good to be hopeful and optimistic, as that is what carries us forward, but sometimes, it pays to be realistic and heed clear and present signs of danger which lie ahead. This is not the kind of pitch where even the best batsmen should be playing shots. Better to bide one’s time and get through this in one piece.