CONFLATION (Contraction + Inflation) is Here. And It Will Stay This Year.

The British politician Ian Macleod is said to have first used the word stagflation in a 1965 speech he gave to the Parliament, where he said:

We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation. And history, in modern terms, is indeed being made.”

The words stagnation and inflation came together to create the new word stagflation. The economic growth in United Kingdom in 1965 was 2.1%, falling to 1.6% in 1966. Consumer prices inflation during the year was at 4.8%. While, this might not sound much, it was the highest in more than half a decade. Inflation in United Kingdom would touch a high of 24.2% a decade later in 1975.

Hence, stagflation became a term which referred to a situation of slow economic growth or stagnation and high inflation.

Many economists and analysts are asking if India has entered a stagflationary scenario now, just like the British had in the mid 1960s. The consumer prices inflation for August 2020 was at 6.7%. The consumer prices inflation for April to August in the current financial year has been at 6.6%, higher than the Reserve Bank of India’s comfort range of 2-6%.

What is worrying is the food inflation level. Food inflation in August was 9.1%, whereas food inflation during this financial year has been at 9.6%. Within this, the inflation in the price of vegetables was at 10.9%, oil and fats at 11.8%, pulses at 18.2% and that of egg, fish and meat at 15%.

At the same time, the Indian economy as measured by its gross domestic product (GDP) contracted by 23.9% during April to June 2020, in comparison to a year earlier. Things are expected to slightly improve during the period July to September 2020, but the Indian economy will contract in comparison to last year.

Hence, during the first six months of 2020-21, India will see the economy contracting and high inflation. Stagflation doesn’t quite represent this scenario, for the simple reason that stagnation represents slow economic growth and not an economic contraction as big as the one India is seeing.

As Macleod put it in the 1960s: “History, in modern terms, is indeed being made.” What was true in the 1960s Britain is also true about the 2020 India.

Given this, it’s time to coin a new word to represent this particular situation of economic contraction plus inflation and call it CONFLATION (I considered Contraflation as well but somehow Conflation just sounded better and the word anyway means the merging of ideas, so, works that way as well).

What does this conflation really mean in the overall scheme of things for India for the remaining part of the year? Let’s take a look at it pointwise.

1) A high inflation, especially food inflation, during a time when incomes are contracting is going to hurt the economy badly. People are having to pay more for food while their incomes are contracting. This means that spending on non-food items is going to come down. This will impact overall consumer demand right through the remaining part of the year. It is estimated that poor households allocate up to 50% of their expenditure towards food. So, conflation will hurt.

Lower consumer demand also leads to a fall in investments simply because there is no point in corporates expanding production, when people aren’t buying things like they used to. This again will negatively impact the economy. (A contraction in investments has been negatively impacting the economy for close to a decade now).

2) High food inflation has primarily been on account of supply-chains from rural to urban India, breaking down. This means that the farmers are not the ones benefitting from the high food prices. Basically, the traders, as usual, are cashing in on the shortage.

This can be gauged from the fact that food inflation as measured by the consumer price index during the year has stood at 9.6%.

Food inflation as measured by the wholesale price index has stood at 3.1%. This clearly tells us who is benefitting from food inflation. It’s clearly not the farmers. If farmers need to benefit, the terms of trade need to shift in their favour, something that hasn’t happened in many years.

3) Some economists have been of the view that food prices will slowdown in the second half of the year, thanks to a bumper agricultural output. Anagha Deodhar of ICICI Securities writes: “We expect vegetable and pulses inflation to start moderating from September 2020 and October 2020 respectively due to base effect. These two items together account for almost one-fifth of food basket and hence meaningful decline in their inflation rates could keep a lid on headline inflation as well.”

While this is true, what this view does not take into account is the fact that covid is now spreading to rural areas. As Crisil Research put it in a recent report: “Of all the districts with 1,000+ cases, almost half were rural as on August 31, up from 20% in June.” This basically means that the supply chain issues when it comes to movement of food are likely to stay, during the second half of the year as well.

Also, the spread of the pandemic could impact the harvesting and the marketing of agricultural products. Hence, overall agricultural production may not grow along expected lines. Given this, food inflation may not fall as much as it is expected to and might continue to remain elevated. Again, a sign of conflation hurting the economy.

4) The medical facilities in rural India are nowhere as good as the ones in urban India (This is not to say that medical facilities in urban India are excellent). The spread of covid pandemic will mean that people will have to spend money treating the disease.

This will lead to the cutting down on spending towards other items. Also, more importantly, the spread of the pandemic will even have an impact on the spending of people who haven’t been affected by it. People will save more for the rainy day. So, conflation will continue to hurt the Indian economy.

5) Another factor that needs to be taken into account is the fact that the money supply* has gone up by more than 11.7% consecutively for the last four months. This hasn’t happened since 2014. What this tells us is that the Reserve Bank of India is really pumping in money into the financial system. If all this money keeps floating around in the months to come, then there is a real danger of this leading to a further rise in prices. (A piece on how the RBI has botched up the monetary policy remains due).

6) But all this remains valid only for 2020-21. Come 2021-22, and India will be back in growth territory again and hence, conflation will be out of the picture. This, as I had explained in an earlier piece, will primarily be because of the base effect.

Basically, the GDP figure in 2020-21 will turn out to be so terrible that it will make the GDP growth in 2021-22, look fantastic. But this won’t mean much because only in 2022-23 are we likely to go past the GDP figure of 2019-20. This means the Indian economy is likely to go back by two years and that will be the cost of conflation.

To conclude, the Indian economy will contract during the second half of the financial year. There is a slim chance of growth being flat for the period January to March 2021. Inflation, even though it might come down a little, is likely to remain high due to the spread of the covid pandemic. Hence, India will see conflation through 2020-21.

* Money supply as measured by M3.