Is deflation giving way to Stagflation? Stagflation is a difficult economic situation when inflation and economic stagnation occur simultaneously and macroeconomic policy fails to address both of these problems at the same time.
QE1 was a big experiment by the US Fed and it hasn’t worked. Though inflation expectations are low and unemployment is high, we are not very far from a situation of real inflation in the US. The US Fed has adopted a formal inflation target and is working towards it. QE2 announced last week for $600 billion, reinforced to the markets that asset bubbles will be tolerated and the US Fed hopes that with rising asset prices, consumers will be confident enough to start spending again. Meanwhile, all the money created out of QE is finding its way into emerging markets and commodities such as gold, silver, sugar, copper, cotton etc. BSE Sensex has registered record highs and Shanghai Composite Index has registered substantial gains since August. The Goldman Sachs Commodities Index has gained 21 per cent from mid-August lows. If growth (US GDP) doesn’t bounce back, then we will end up with an ugly situation known as stagflation
Back home in India, we are already seeing signs of overheating. The negative real interest rates have resulted in diversion of money towards consumption expenditure and investments in alternate assets. Primary article inflation is above 15 per cent levels inspite of the above average monsoon. Schemes like NREGA and other populist measures by the government are causing a structural shift in income consumption pattern which is skewed towards key protein sources such as pulses etc. Their volatile supplies have put an upward pressure on headline inflation. In manufacturing space, automobiles and steel prices are rising everywhere as demand is outstripping supply.
However, over the medium-term, domestic consumption will continue to drive the India growth story. The fiscal situation is also expected to improve. The current account deficit should also moderate to 2 per cent of the GDP and monetary policy measures will push up real interest rate. In the short-term, currency wars have led to lot of short term flows finding their way into India and in turn leading to asset classes getting frothy, be it equities or real estate. Inflation is becoming sticky in nature and although monetary tightening is taking place, the rate hikes are too small and too late in making real interest rates positive. Hence, there is a fear that unless the punch bowl is taken away completely, we could experience double-digit inflation, but this time with much lower GDP growth rate.
Thus, with more and more money getting printed across the world, inflation is set to be in business for more time than expected. In such a scenario, it is imperative for the investors to develop exposure to hard assets which would sustain even during stagflation periods.
The author is Head Fixed Income, Canara Robeco Asset Management
