Following the Keynesian Revolution and the famous Phillips Curve, it was widely believed that there was a tradeoff between price stability and growth. Since inflation and unemployment (a proxy for low economic growth) were negatively correlated, the use of fiscal and monetary policy appeared simple: countercyclical during inflationary episodes and expansionary when growth dipped.
This simplistic Phillips Curve relationship was undermined by the ?stagflationary seventies? that opened up the possibility of a positive correlation between unemployment and inflation, and through the works of Nobel laureates Edmund Philips and Milton Friedman. There is no long-term tradeoff between price stability and growth in the expectations-augmented Phillips Curve. Countercyclical policy is now tempered with concerns over inflation. Governments have moved away from discretionary to rule-based fiscal and monetary policies to stabilise growth. The Taylor Monetary Policy Rule, and the European Union Maastricht Treaty norm of containing the fiscal deficit within 3% of the GDP, are now widely accepted as conducive to macroeconomic stability.
Though possibly inspired by neo-Keynesianism, in retrospect the response of the US Fed under Paul Volcker to stagflation in serially raising the Fed Funds rate, till the effective rate crossed 19% in 1981, is also consistent with the monetarist assumption that there is no Phillips long-term tradeoff. It was only after the monster of inflation was tamed that the problem of low growth was addressed by lowering interest rates.
There are widespread fears that the world may again be headed for stagflation. In sharp contradistinction to the Volcker era, and the expectations augmented Phillips Curve, the US Fed and Bank of England have loosened monetary policy to counter the systemic subprime financial crisis and attendant recessionary fears, overriding inflationary expectations. There has, however, been no such pump-priming in Europe, also reeling under recessionary fears but with the ECB steadfast in its focus on inflation.
Arguably growing above potential over the last few years, the Indian economy has lost momentum in recent quarters, at least partly the result of RBI?s relatively tight monetary stance to dampen demand. WPI inflation has, nevertheless, crossed the 7% mark, with consumer price inflation running a good 150 basis points above the WPI. India cannot be insulated against stagflation?were it indeed to occur?in an increasingly integrated world.
While there is unanimity that primacy should be accorded to containing inflation, there are differences of opinion on the effectiveness of monetary policy in combating the emerging stagflationary circumstance. Many analysts argue that since the current spurt in inflation is cost-push?the outcome of global short supply?rather than demand pull, monetary tightening would simply end up hurting growth without significantly reducing inflation. The burden of dealing with agflation in particular, which has a disproportionate fallout on the poor, would mostly fall on fiscal rather than monetary policy in any case.
There are, however, several problems with the argument that tight monetary policy is ineffectual in dealing with the current stagflation threat.
First, short supply is simply the flipside of excess demand. The distinction between demand-pull and cost-push inflation is essentially neo-Keynesian. The neo-Keynesian view of stagflation is that it is caused by cost-push inflation, and its strategy for dealing with it is to cut money supply to bring down inflation to manageable levels before increasing money supply to spur economic growth. This ?disinflationary? neo-Keynesian policy was pursued to good effect by the US Fed under Paul Volcker during the Carter administration.
Second, although most of the inflation in tradable goods over the past year, in India and abroad, has been in oil, commodities and food, where global demand-supply imbalances have emerged, domestic money supply can nevertheless impact the rate of inflation on the margin. Indian inflation has been relatively benign by global benchmarks over the past year, partly the result of rupee appreciation and RBI?s tight monetary stance. Nevertheless, money supply growth of over 20% during the last three years substantially exceeds nominal GDP growth, mostly the outcome of large capital inflows and hence inherently inflationary.
Third, even as the IMF has given confusing signals to developing countries to use contractionary fiscal policy to counter the expansionary impact of large capital inflows on the one hand, and expansionary fiscal policy to bolster growth on the other, India?s fiscal stance following the recent Union Budget is expansionary and needs to be counteracted through a tight monetary policy. This is indeed the current stance of the central bank that hiked mandatory reserve money requirements even as it kept key policy rates unchanged in its 2008-09 annual policy statement of April 29, 2008.
Following continuing serial Fed rate cuts, there is the danger that widening spreads between US and Indian real interest rates could induce more foreign capital to flood the country. However, the ongoing financial crisis in OECD countries and the resultant flight to treasury bonds may have stalled this danger for now. Besides, a slight appreciation of the rupee might in fact help moderate inflation.
?The writer is a civil servant. These are his personal views