Fears of Stagflation Impacting Markets : Daily Current Affairs

Relevance: GS-3: Indian Economy, mobilisation of resources, growth, development and employment.

Key Phrases: Inflationary shocks, Supply side constraints, Ukraine war, Stagflation, Central bankers, Inflation, Recession, Stagnant economic output, Unemployment, Supply shock, Bear-market strategy

Context:

Authority’s worldwide, particularly central bankers, are feverishly trying to formulate the appropriate set of policies to ensure that inflation, currently running at multi-decade highs in some advanced economies including the U.S., is cooled without triggering a recession.
Former Federal Reserve Chairman Ben Bernanke told The New York Times last month that he foresaw a period in the near future “where growth is low, unemployment is at least up a little bit and inflation is still high”, which is termed as stagflation.

Stagflation

Stagflation is an economic event in which the inflation rate is high, economic growth rate slows, and unemployment remains steadily high. Such an unfavourable combination is feared and can be a dilemma for governments since most actions designed to lower inflation may raise unemployment levels, and policies designed to decrease unemployment may worsen inflation.
Stagflation refers to an economic situation marked by stagnant economic output and high price inflation. The idea became popular during the 1970s when the U.S. economy witnessed high price inflation due to the oil shock as well as an economic recession marked by negative economic growth.

Key Macroeconomic Gauges:

Most economists typically focus on the three key macroeconomic gauges to assess the health of an economy.

Economic output measured by Gross Domestic Product (GDP).
The level of unemployment.
Inflation or the pace at which the prices of goods and services are rising in the economy.

Challenge for policymakers:

The challenge for policymakers, especially central banks, is
- To ensure optimum conditions whereby output grows at a healthy pace.
- Helping businesses in the economy to create jobs at a steady pace.
- Keeping unemployment low.
- An atmosphere of prices remain relatively stable.
However, in the real world, more often than not, high economic growth invariably spurs faster inflation, which is why many central banks have a specific mandate of ensuring that the pace of price gains does not exceed a specified target level or range.
The most difficult problem for policymakers is when inflation runs high even as economic output either stagnates or, worse, shrinks. The slowdown in economic activity, in turn, leads businesses to shed jobs and the resultant situation is termed as ‘stagflation’.

Unemployment and Inflation

The idea of stagflation is closely linked to the Phillips curve which tried to establish that there was a negative empirical relationship between unemployment and inflation. That is, according to the Philips curve, when unemployment is high, inflation is low and when unemployment is low, inflation is high.
The supposed negative relationship between unemployment and inflation was explained by Keynesian economists as a natural phenomenon caused by the prevalence of sticky prices. According to these economists, unemployment in an economy rises when wages fail to drop quickly enough to adjust to changing economic conditions.
Workers are seen as unwilling to accept a cut in their wages, thus forcing businesses to let go of some of their employees in order to adjust to higher wages instead of trying to lower wages. This can affect the overall output of an economy as fewer people are now employed.
Many economists during the time, in fact, came to believe that it was the duty of central banks to carefully manage price inflation in such a way that unemployment is kept within reasonable limits.
Inflation was supposed to be maintained at a certain level such that there is no excess unemployment and the economy is functioning at its full capacity. The belief among economists was that workers could be tricked into accepting lower real wages (but higher nominal wages) when prices rise at a certain rate, thus ensuring that workers are employed and the economy continues to function at full capacity.

Do you know?

Four economic theories

The 4 economic theories are
- supply side economics;
- new classical economics;
- monetarism and
- Keynesian economics.
Supply-side economics postulates economic growth can be most effectively fostered by allowing free trade, decreasing regulation, and lowering taxes.
New-classical economists believe that, to develop, countries must liberate their markets, reform labour markets, privatise state owned industries, encourage entrepreneurship (risk taking).
Monetarism emphasizes the role of governments in controlling the amount of money in circulation.
Keynes advocated for increased government expenditures and lower taxes. Keynesian economics is considered a “demand-side” theory that focuses on changes in the economy. During the 1930s in an attempt to understand the Great Depression, the British economist John Maynard Keynes developed Keynesian theory in economics.

What has sparked the latest concerns about stagflation?

While the outbreak of the COVID-19 pandemic and the curbs imposed to contain the spread of the virus caused the first major recent economic slowdown worldwide, the subsequent fiscal and monetary measures taken to address the downturn, including substantial increases in liquidity in most of the advanced economies, fuelled a sharp upsurge in inflation.
While the Fed and the Bank of England are among central banks that have started raising interest rates to cool soaring prices, the ongoing war in Ukraine following Russia’s invasion of its southern neighbour and the consequent Western sanctions on Moscow have caused a fresh and as yet hard-to-quantify ‘supply shock’.
With the prices of commodities ranging from oil and gas to foodgrains, edible oils and fertilizers all surging sharply in the wake of the conflict, authorities face an uphill battle to contain inflation that is now less a function of demand (and so can be controlled by regulating credit) and almost entirely caused by supply factors that are far harder to manage.

How to curb stagflation?

There are no easy solutions to stagflation.

Monetary policy can generally try to reduce inflation (higher interest rates) or increase economic growth (cut interest rates). Monetary policy cannot solve both inflation and recession at the same time.
One solution, for country like India, to make the economy less vulnerable to stagflation is to reduce the economies dependency on oil. As rising oil prices are the major cause of stagflation.
The only real solution is supply-side policies to increase productivity, this enables higher growth without inflation.

Way Forward:

In 2022, we are seeing a rise in global inflation due to supply side shocks, rising oil prices and supply chains adjusting to Covid shocks. However, with high inflation, we are also seeing rapid growth as it recovered from Covid slump.
However, the economic growth figures are slightly misleading. Most consumers don’t feel there is ‘growth’ of 7-8% because real wages have been squeezed by rising prices. Therefore, it may feel like stagflation to many consumers even if economic stats don’t show classic stagflation.

Source: The Hindu

Mains Question:

Q. Will inflationary shocks and supply side constraints due to the Ukraine war lead to more challenges like stagflation? Examine.