Deeper contraction in output and sustained inflationary pressures could be policymakers’ nightmare
It is now apparent that India’s economic fate is synchronised with the fate of the disease. The control and containment of Covid-19 spread has become chaotic, and the economy’s recovery is well-entangled in the mess of its handling. The near-consensus growth estimate most analysts are veering towards is 5% contraction in real aggregate output; with 4% inflation, nominal GDP growth may well be negative, around -1%. In the worst-case scenario, real GDP could shrink more severely, -9% some say, as all risks incline downwards. Such a brutal loss of demand should be strongly deflationary. However, there are several reasons why inflation could trend up and beyond the upper 6% bound. A recession of such proportions, with high inflation, is possibly the most dreaded combination imaginable for an economy aspiring to recover. But, it seems that this is destined to be the case as an economic mess is unfolding right amidst the pandemic.
An exceptionally severe output contraction is expected in the short term. Any differences arise from the visualised scenarios and probability weights assigned to each of these. Although all estimates will be constantly revised as the pandemic evolves, it is not unreasonable to expect India’s loss of economic output to exceed most other countries’ because of the strictest lockdowns. The economy will also operate below potential as long as Covid-19 endures. For example, the consumption of many goods and services is likely to remain depressed from voluntary restraints and milder containment measures; fall in incomes and rise in unemployment will take away another chunk of private consumer demand. Investment, which depends upon demand—current and future, domestic and global—and uncertainty about this, will suffer too; firms have already held back, or announced cutbacks in business spending. Besides companies and households, government expenditure could decline—to offset revenue losses, or restraints in planned spending to minimise instability risks from fiscal imbalances.
On the supply side, the depressing effects of consumption, output constraints from disruptions within the country and abroad (e.g., supplies of raw materials, other basic and intermediate, semi-finished inputs), and from changes in global prices of oil, commodities, and currencies are a mixed force as far as inflation is concerned. For now, the global price collapse in commodities and oil is deflationary. It is also presumed the retail price-push observed in the limited April data, due to supply curtailments from the shutdowns, will ease upon unlocking.
But, even if output constraints persist, one would imagine the intense growth contraction, weak investment, and consumption should all reflect in low inflation. This is RBI’s characterisation of the near-term inflation path it shared last Friday, lowering the policy rate 40bps more to 4%, coupled with regulatory easing measures. However, there are at least four reasons why inflation may not conform to this picture, and trend up instead.
One, producers of goods and services who remain alive and functioning during the pandemic will, perforce, operate under social distancing and public hygiene constraints. Therefore, they will function below, or at low capacities. Additional cost-push factors exist in the form of input limitations—physical inputs obtained locally or overseas, as well as the evident and emerging scarcity of labour. But, the overriding factor is the uncertainty that exists on both sides—demand and supply. Although demand reduction is expected, for example, the magnitude remains extremely unclear. The uncertainties on the supply side are even less implicit, e.g., the possibilities of the damage Covid-19 could inflict upon less-resilient suppliers, resulting in closures or exits—such permanent supply destruction could feed back to the stronger, larger buyer firms. When output is constrained from most input sources and there is uncertainty about demand and supply, conditions are ideal for producers to raise prices—the survivors acquire pricing power from shrinkage in the supply base, amongst other factors.
Two, international prices of commodities and crude oil can only pick up henceforth—the magnitude of increase can be speculated, but not the direction. The tremendous monetary-fiscal stimuli and support provided by the advanced nations to keep their economies functioning close to potential is a strong impulse. An early indicator is their recent rebound, following the easing of lockdowns, in anticipation of returning demand. Domestically, fuel taxes and duties have already been raised; there is little scope for pass-on to consumers. The impact of any increase will devolve upon public finances, which are leaning heavily on fuel revenues to tide over other losses, and a risk to fiscal stability.
Three, increased protection, or higher import tariffs increase the gap with global prices, preventing the importation of any disinflation. An even more adverse outcome is that in a constrained and uncertain environment, protection provides incentives to domestic producers for monopolistic pricing. The competitive pressures that put a lid on domestic prices are increasingly reducing. RBI has urged the government to rethink import tariffs on pulses right now, but, when inflation becomes a headache that it currently may not be, there will be more items.
Four, fertile ground is forming for the transmission of food prices to the inflation expectations of households, viz. the labour shortages that are coming up fast. Urban wages could soon come under pressure next, especially in construction. The usual rural-urban migration could break this chain, but the pandemic panic is unlikely to ebb in the foreseeable months. It also remains to be seen to what extent the scars of their distressing return home lift from the minds of the workers.
The monetary policy committee has regarded April’s food price spike as temporary and chosen to look through this. It expects that post-lockdown, prices are likely to moderate below target (4%) from normal monsoons, low commodity prices, and poor demand. However, inflation may not ebb as anticipated for all the above reasons. Generalised inflation was already in the 6% region in March, and possibilities of inflationary expectations rising on account of wage pressures and an uncertain economic environment cannot be ruled out. Monetary abundance is also a potent base.
India could, thus, see severe loss of output and high inflation. This combination is, or rather should be, a policymaker’s nightmare. With the government invoking ‘vocal for local’, self-reliance or ‘Atmanirbhar Bharat’, offering market protection and reduced competition, it is creating a firm base and stoking the grounds for inflation. Evidently, a recession with high inflation is not nightmarish.
The author is New Delhi based macroeconomist. Views are personal