Is Stagflation on the Horizon: Buisness Line: 18th July 2008

To contain cost-push inflation a demand-pull solution is being used by central banks. This has the potential to slow down growth.
Stagflation is a phenomenon which surfaced in the 1970s when the world went through the first oil crisis. Curiously this was also the beginning of the temporary end of Keynesianism because it was shown for the first time that inflation and unemployment can coexist.
We are now in the midst of another oil crisis and the question which is being raised is whether we are moving towards stagflation once more. The question is germane to most countries, especially the US, the UK, the Euro zone and India. The responses of monetary authorities have, however, been disparate.Global phenomenon
The rise in inflation is a concern everywhere, and is truly a global phenomenon. The US is worried, and so are the ECB (European Central Bank) and BoE (Bank of England). We in India are petrified of double digit inflation but seem to have reconciled to it after the initial umbrage.
It is agreed that inflation is a cost-push phenomenon with higher oil and food prices driving it up. And it is also accepted, albeit very reluctantly, that there is little that can be done as both food and oil prices are outside the purview of policy action in the short run.
There appears to be no solution to the oil price crisis as new highs are reached. Food prices remain an enigma, with dwindling stocks leading to riots in Mexico, Morocco, Uzbekistan, Yemen, Guinea, Mauritania and Senegal. The rich nations are also worried on account of the diversion of land to produce crops for bio-fuels. Tough stance
In this situation, most central banks have taken a tough stance, of increasing interest rates to control inflation. The ECB has done it and the RBI is doing the same. However, the Fed remains un-nerved and the BoE is not reducing the rates any further.
Inflation is just above 4 per cent in the US and is inching towards this mark in the Euro zone, which is well above the 2 per cent norm that has to be pursued. In the UK inflation is around 3.5 per cent while it is getting close to 12 per cent in India. GDP growth expectations vary, from 7-8 per cent in India to 1.7 per cent in the UK and the Euro zone; it is expected to be lower at 1.4 per cent in the US.
The central banks are in the process of tightening the monetary tools, such as interest rates and reserves. What happens when interest rates are raised? Consumption and investment get curtailed, and this could lead to a cut back in production and accumulation of stocks. Under such circumstances, labour is released leading to higher unemployment. While this is an extreme situation, there would definitely be a slowdown in employment growth. Back to 1970s?
Therefore, there would be a throwback to the 1970s, with high inflation, low growth and unemployment. The route, however, would be slightly different. In the 1970s, the oil shock caused GDP to fall and unemployment to increase. The governments increased expenditure to prop up the economy. But this did not lead to higher production and resulted in inflation. Today, higher oil prices have not resulted in low growth — in fact growth in 2006 and 2007 has been fairly satisfactory throughout the world.
However, to contain cost-push inflation a demand-pull solution is being used by central banks, which has the potential to slow down growth.
The explanation given by most central banks is that what matters more today is not inflation so much as inflationary expectations.
Central bank action sends strong signals to the people that it is keen to protect the price level and, hence, ensure stability. This counters the higher spending that comes into play when wages rise in response to inflation.
But if one looks at the Federal Reserve, it has taken a more liberal view and prefers to protect growth even if it means a little more inflation. The initial conditions in the US were different from those in the ECB zone or India, as it was buffeted by the financial crisis which threatened the edifice of growth. The priority was to bring about growth at any cost (elections too are around the corner) which made the Fed reduce interest rates to 2 per cent.
After embarking on such a path, it would have been difficult to take an aggressive stance on inflation. The best that it is doing today to counter inflation is not to lower rates further. There were expectations of the Fed lowering interest rates further given the rather nebulous growth prospects in the economy.
The ECB is more worried about the inflation rate being twice the acceptable level and has evidently put growth as a secondary objective. Therefore, one may expect the ECB to raise rates further in the course of the year if inflation continues to bite. The BoE has resisted the urge to lower interest rates and has preferred to take the more conservative route of neutrality in the present circumstances. Inflation concerns
The RBI, on the other hand, has little choice as inflation is a major concern and is politically unpalatable. Hence, with growth being less of a concern and inflation the major stumbling block it is not surprising that the focus has been on inflation. But this runs the threat of slowing down the economy and leading to a near stagflation state as the growth projections have now slipped to 7-8 per cent from 8.5-9 per cent.
Hence, while technically it may not be a recession, which in the West is defined as two successive quarters of negative growth, such a slowdown would mirror the effects of a recession.
Thus one does witness a varied set of reactions from central banks across the world motivated by different concerns. There is really no unique approach to a common problem: one size cannot fit all.