High levels of uncertainties add to stagflation risks

A spate of sudden risk events has lifted uncertainty to extreme highs. Supply shocks and inflation risks originating from the Russia-Ukraine war and related developments have radically turned around the outlook from what it was in February. The Reserve Bank of India (RBI) then believed that inflation would decline after its January peak while recovery progresses. But skyrocketing crude oil prices amidst elevated uncertainties have upset the math. Stagflation risks have grown.

Acknowledging the fresh developments, the central bank recently communicated its assessment of their effects upon the economy. It also shared its views on the new balance of risks which, it said, prompts re-evaluating the inflation (4.5 percent) and growth (7.8 percent) forecasts for FY23 next month. It further clarified its reaction function, saying the oil price shock will be considered a supply shock for policy purposes.

The communication is important because in a highly-uncertain environment, it helps agents decide how to act. It also serves to influence future expectations. It imparts confidence by reassuring the macroeconomic fundamentals and policies are in control. Escalated uncertainties and shooting crude oil prices had increased risk aversion, accelerating outflow of foreign capital from domestic markets along with revisions of inflation, growth, and current account forecasts.

Supply shocks, which move output and prices in opposite directions (unlike aggregate demand shocks that move the two in the same direction), create a trade-off between the two, forcing a choice upon central bankers. The trade-off is more difficult when recovery is still not secured, as the case is at present. The RBI’s communication implies that the monetary policy will remain supportive (continuation of the accommodative stance) while the supply shock price pressures will more be managed through government interventions.

Inflation needs careful, and effective minding. Even without the pending fuel price adjustments, and fresh price pressures from the Russia-Ukraine disturbances, retail inflation breached the tolerance limit (6.1 percent) in February, a minor rise from January (6 percent). Food and core inflation ranged similar, the former rising with slight moderation in the latter. Steady sequential strength of the core inflation momentum and its broad-based pick up indicated sustained passthrough of costs, and re-opening inflation in services. Subsequent price developments are likely to reinforce these trends.

The portents are not encouraging. Producer price inflation, where manufacturing price growth paced 9.8 percent last month, has reversed its sequential decline from October 2021 in this year. Maintained intensity of price pressures is clearly testing absorption capacities of firms despite the enlarged gap in output. That means persistence of global price increases may be hard to withstand irrespective of demand strength, impacting core inflation that will also gain from normalising activities.

To avoid hurting private consumption and stagflation forces from building up, the government will have to intercede effectively to restrain food, fuel, and fertiliser prices. The RBI Deputy Governor alluded to the headroom from fuel levies, which could hold off pressures for a while; this is being used as retail fuel, and fertiliser prices remain frozen. Abundant food stocks are helpful, while the monsoon features are not yet known. The endurance of the oil shock is key determinant of supply management because the balance between complete absorption by the government and sharing it out is delicate — prolonged pressures will test fiscal capacity that is stretched and finite, while a slowing pace of income growth could limit absorption by consumers without injuring demand.

Tighter external liquidity and financing costs also weigh in. The US Federal Reserve’s reversal began last week with its first interest rate hike, signals of more ahead with ‘acute awareness’ of the need for price stability. Slowing growth and/or higher inflation could also test endurance of foreign capital inflows, and exchange rate. Notably, cumulative portfolio capital outflows in the last five months equal that in June-August 2013 (taper shock), and in April-Dec 2008. No doubt, financial deepening over time increases resilience as do forex reserves, but there are thresholds nonetheless; for instance, the short-lived oil price spike of 2017-18 did not immunise the rupee to disturbances, including the current account.

Gold imports, which respond to high inflation and negative real rates, are another factor. Higher global prices also showed imports outpacing export growth in February trade data. A persistence of this trend, and/or slowing of exports along with world demand, could risk revision of current account deficit projections (currently 2.5-3 percent of GDP). It’s not yet clear how much of the export betterment has been due to demand factors, or a structural increase. Finally, high inflation and interest rates also turn attention to debt and deficit levels, which are precarious.

The hope is that the RBI can manoeuvre a soft landing whereby inflation returns to its 4 percent target, and economic recovery remains strong. Not easy with negative terms of trade, a slowing world economy, and higher global inflation, besides geopolitical and other uncertainties.

Renu Kohli is a New Delhi-based macroeconomist. Views are personal, and do not represent the stand of this publication.