Stagflation: How much of a threat is it?

Last year’s predictions were of strong economic rebound, with the scenario painted by economists resembling the “roaring twenties”, a period of consumerism following a tragic pandemic. Fast forward some months and the reality looks more like a return to the 70’s, when the Organisation of the Petroleum Exporting Countries imposed an oil embargo on America, triggering inflation to double-digit rates as economies around the world stagnated, a phenomenon known as “stagflation”, which is particularly tricky because it combines two issues that do not normally go together. (Valentine Romei, 2022)

As the economic recovery observed through 2021 loses momentum, the fear of stagnation rises. When combined with the double hit by Covid-19 and the war in Ukraine, we observe inflation rates that have exceeded all expectations, beating record levels in years. It is the perfect storm, and there are not many monetary tools to address it: while interest rate raises may help curb inflation, they will further depress economies. Loose monetary policy risks pushing prices even higher.

So, the question arises: to what extent should we expect a rerun of the 70’s shock? Back in the 1970’s, inflation rose to double-digit rates for almost a decade, pushing unemployment to high levels in many advanced economies and leaving in the past the boom years after the second world war.

Some similarities between the two economic pictures arise, however, it is also argued that the 1970’s provide little guidance to understand the current crisis. Some parallels can be established, namely regarding food and energy price shocks, with gas and coal prices close to record levels in Asia and Europe, and stocks of both fuels reaching concerning low levels. However, while today’s steep increases in commodity prices echo those in the 1970’s, some differences arise (The Economist, 2021). Households can sustain higher energy costs with accumulated savings during the pandemic and rich economies have introduced measures like fuel subsidies to shield the most vulnerable from rising prices.

Vicky Redwood, Economist at Capital Economics, states that high inflation is only likely to be sustained like in the 1970’s if wage-price spirals develop, as the historically tight labour markets in the US and Europe increase the risk of inflation becoming more entrenched in the economy. (Redwood, 2022) With private and public debt levels at historic highs as a percentage of GDP, central bankers can only go so far with policy normalisation before risking a financial crash, even though proceeding slowly risks de-anchoring inflation expectations and triggering a wage-price spiral, warns Nouriel Roubini, Professor of Economics and International Business at New York University Stern School of Business. (Roubini, 2022)

Andrew Kenningham, from Capital Economics, believes growth in “the Euro-Zone economy will do no more than flat-line during the second and third quarters of this year”, with headline inflation falling back later this year, but being much higher than the consensus expects for the year as a whole. In the same publication, Kenningham considers the ECB will soon end net asset purchases and start raising interest rates, predicting a 1.5% peak next year, also well above the consensus forecast (Kenningham, 2022). In fact, Christine Lagarde has signalled for the first time that the European Central Bank’s eight-year experiment with negative rates should end in some months.

All in all, while this time around it might not feel exactly like it did in the 70’s, it will still feel like stagflation.

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References:

Kenningham, A. (22nd April 2022). A year of stagflation. Obtido de Capital Economics: https://www.capitaleconomics.com/publications/european-economics/european-economic-outlook/a-year-of-stagflation/

Redwood, V. (16^th May 2022). Is a recession necessary to bring down inflation? Obtido de Capital Economics: https://www.capitaleconomics.com/publications/global-economics/global-economics-update/is-a-recession-necessary-to-bring-down-inflation/?utm_source=website&utm_medium=rss&utm_campaign=global+economics&utm_content=item_link

Roubini, N. (30th  March 2022). Is the New Stagflation Policy-Proof? Obtido de nourielroubini.com: https://nourielroubini.com/is-the-new-stagflation-policy-proof/

The Economist. (7^th  October 2021). Is the world economy going back to the 1970s? Obtido de The Economist: https://www.economist.com/finance-and-economics/is-the-world-economy-going-back-to-the-1970s/21805260

Valentine Romei, A. S. (2nd May 2022). The global stagflation shock of 2022: how bad could it get? Obtido de The Financial Times: https://www.ft.com/content/d490ef4e-3187-471e-84ff-9c065871a1a5