Has stagflation arrived? Morgan Stanley’s Chetan Ahya on what to look for

The RBI needs to kind of stay on that track and take policy rates higher. We do think that the policy rates needed would be quite meaningfully higher than where we are today and so we have the terminal rate at 6.5%. We expect that the RBI will lift policy rates by 50 bps in the June meeting and then another 50 bps in the August meeting. That is the pace which should be required to ensure that inflation expectations do not become a problem for India. So yes, we do expect normalisation to happen at a rapid pace now.

Is stagflation emerging as a real risk globally?
We have seen that stagflationary impulse emerge even more loudly with the invasion of Ukraine by Russia and that is still reverberating through the global markets and we still continue to have commodity price pressures. But we would not call the outcome of the state of the economy as stagflation because we are still seeing expansion in various parts of the world, especially in the US, which is an important economy to qualify us to be in stagflation or not.

One important variable that we would look at as a stagflation marker is rising unemployment. Right now we do not have that. I would say it is a case of moderate growth and high inflation rather than a state of stagflation.

What does that do to growth projections back home? Will you be revising your growth projections going forward? What could potentially change the tide when it comes to the overall sentiment of growth picking up given that we are in a fairly precarious environment?
India is part of this world. If the world is seeing this tension because of higher commodity prices and in terms of trade shock, India is also seeing that pressure. We have been cutting our growth rates for India and right now, for CY2022, our GDP growth is at 7.5% which is a 12-month ending December ‘22. The next year we are at 7.1%.

We do see downside risk to that now because of the persistent pressure on commodity prices, especially oil, and at the same time we are seeing China slowdown and that will have an impact on global trade and global growth. There are some downside risks to these numbers but India will still be in a much better shape, compared to the rest of the world because India is also finally seeing the benefit of full reopening with the Omicron wave behind us. The cyclical momentum in the economy is relatively healthy and it can withstand the downtrend or downward pressure from higher commodity prices and still deliver healthy growth numbers.

The rising inflationary scenario pertains to India as well as the world at large. While central banks are acting, the Fed being ahead of the curve, in this highly inflationary, extremely volatile scenario, will they be really effective considering inflation largely is supply-led?
I think both the Fed and the RBI are now trying to address the supply side inflation by tightening money policy. The way I would think about the Fed and even India is that the economy has recovered to very strong levels. The US it is back to pre-Covid path in terms of GDP and the labour market is extremely tight. They need to manage the demand side and keep that under check to ensure that they do not lose control on inflation expectations.

So far, they have been well behaved but therefore need to be on time and lift interest rates to ensure that we do not have second round effects of rising commodity prices feeding into inflation expectations because demand is also pretty strong.

The same is the case with India. My previous boss Stephen Roach, who is ex-Morgan Stanley chief economist, had a very important lesson, that when you are in a crisis, you leave monetary policy in crisis level of interest rates; but when the economy is going through some kind of recovery, even if it is not that strong, you need to have your monetary policy or interest rates move in line with that type of recovery.

In India, while we are not seeing output gap closing, recovery has been reasonable with the Omicron wave being behind us. The PMI numbers for both manufacturing and services show the recovery is pretty robust and so to have low level of interest rates while your economy is in a robust shape and inflation is picking would not be fair. What RBI is trying to do is to normalise monetary policy in the context of the fact that the recovery has been relatively strong and we are running the risk of losing control on inflation and inflation expectations by leaving interest rates in such high levels of negative real interest rates.

We have seen a 40 bps out of turn move from the RBI already. What is in store for us? Are we looking at just the beginning of an interest rise rate trajectory?
I think yes. I would say that we are at the beginning of a rising interest regime. Our view is that inflation will moderate and it will go below 6% , to around 5.5% but even if we are at 5.5%, if you think that the normal real rates in the system should be at least about 100 bps, we need to get back to 6.5% nominal repo rate. That is the reason why we are forecasting terminal policy rate at 6.5%.

Mind you, there are upside risks to that inflation forecast of 5.5%. So, in our minds, 6.5% is the base case. There is a risk that RBI may have to do more if it wants to have the real interest rates in the range of 100 bps positive.

Typically a cycle lasts for many years. It starts with monetary support, then leveraging and capex starts and then we see a reversal. So first, there was a crisis, we came out of the crisis and just when the leveraging and the capex cycle started, a reversal has started. Isn’t the cycle too short lived? Ideally a cycle should have lasted a little longer?
That is a very interesting question. So first of all, when you are thinking about business cycles, the US is the one which determines the global business cycle duration and the time period for which it will last. When one thinks about the US, we had written a report about a year and a half back on this topic that we are going through a regime shift with inflation being structurally higher.

When inflation returns, business cycles will be hotter and shorter. If you think of it, in this cycle, what we have seen in the US is that policy response have been so strong that we have reached low levels of unemployment, which would be closer to a late cycle period in the shortest possible time and that is the reason why one should think about business cycles being shorter now than what they used to be before.

In the last four business cycles, the average duration has been about nine years and now for this cycle at that point of time, it could be about four to five years and that is because of this dynamic that I mentioned to you, now there is a regime shift. Fiscal policy is going to be more active. Fiscal policy helps us to get back to the low levels of unemployment much faster and therefore one has to think about the risk-off business cycles ending earlier than before.

One other point to keep in mind in the context of business cycles is that in the last 10 years, before Covid, we had structurally low inflation. On any sign of a threat to the business cycle and downside risk to growth Fed could come to the rescue; but now, when there is inflation, the Fed cannot come to the rescue and try to protect growth outlook because it has to also focus on inflation.

We saw the geopolitical tensions putting in downside risk to growth, but the Fed cannot just focus on growth risks, it has to look at inflation risks as well. That is the challenge of this new regime that we have entered into.

In a commodity boom and a bust cycle, the wealth effect will shift from a consumer to producers. So what happens to the boom part of the world – whether crude producers or metal producers? Do you see significant growth in those pockets and can they compensate for global growth?
That is a positive story which can be working on and overall basis as a net accretion to the global economy only to the extent to which you do not have a big inflation challenge. Now that inflation has become such a big issue, we are going to see a challenge for the global business because that is going to be net negative with central banks having to contain growth and slow growth to ensure that inflation does not become a bigger problem than what it is already.

I would say that one can look at the parts of the world which are benefitting on account of higher commodity prices but when you think about the world as a whole, this has now gotten into a stage where it has got to be net negative for growth outlook.

Is it time to say hello to stagflation? As a student of economics, stagflation is the worst thing that anybody can ask for. Is stagflation here now and is it here to stay?
I do not think that we can still call it stagflation, I would describe this as moderate growth and even higher inflation but not stagflation. We do not have the stagnation part of stagflation definition being met as yet.

In India’s perspective, growth rates below 5% would be some kind of stagnation scenario but we are not forecasting that. From the world perspective, one could say recession is global growth below 2.5%. We are not forecasting that either. It is still a higher inflation regime rather than stagflation.

Just to wrap it up, the change in terms of the preference of PLI schemes, China plus one policy and less and less dependence on crude as a preferred mode of transport – these are large changes which will have an impact on the way how world would be producing, consuming and manufacturing. What are your thoughts on these big trends related to PLI schemes in India or China plus one policy?
We are very constructive on this development as far as India is concerned. There are two forces at play. There is a shift taking place in the world with the emergence of a multipolar world. On top of it, we have had the added challenges of the supply side disruption that are going through in China right now, because of Covid restrictions that are triggering a shift in multinationals thinking and their effort to diversify supply chains.

In India, it is definitely coming up as an alternative but the more important shift and change is that the government is making a concerted effort to focus on manufacturing and manufacturing exports. We have always seen that challenge in India that the focus was more on redistribution rather than trying to push investment. But now over the last three years, there is a consistent effort from the government side to push investment and encourage the corporate sector to make profits and create jobs. The big shift that is taking place in India is a more important driver for the India story.

We are expecting manufacturing to see a bigger share in GDP in India and at the same time we are expecting India to gain market share in global goods exports so that it is not just dependent on the global beta of trade growth improving. but it gets the alpha of increasing market share in global goods exports. We have already got the evidence in the last six months. India’s market share in global goods exports is rising and we think this will be a multi-year trend.