Few prospects are worse for an economy than stagflation. The combination of stagnation with steeply rising prices has nothing to recommend it. Asset values are rapidly eroded by inflation, as are returns on capital, but, unlike the inflation that might accompany high employment, it is equally miserable for workers as wages fall and jobs are lost.
Fortunately it is clear that the global economy is not yet experiencing this unhappy outcome. While inflation has risen as economies have reopened, so has growth. A slight deceleration in the pace of expansion is to be expected as economies normalise after the pandemic. It would be more accurate to describe recent experience solely as reflation. Indeed for the past two years, market chatter has whipsawed from the pre-pandemic forecasts of persistent “lowflation” to deflation during lockdowns and then reflationary growth, brought on by stimulus and vaccines. The latest talk of stagflation may, similarly, be an extrapolation from temporary trends that may soon reverse.
Nevertheless the combination of supply chain disruption, high oil prices and labour shortages means the risks are worth taking seriously. Temporary price pressures could be embedded in more long-term expectations and last even as the boost to growth from reopening fades away. For the moment, all that central banks can do is be alert to the risks and continue with their plans to gradually unwind their stimulus programmes. Governments should think creatively about supply-side reforms to ease bottlenecks.
Stagflation is indelibly associated with the 1970s, when high rates of postwar growth started to fade and inflation surged, particularly after the “oil shock” following the 1973 Yom Kippur war. The world, however, is a very different place today. For a start, organised labour is weaker. The kind of wage-price spiral that was brought on as workers, or their representatives, tried to keep pace with accelerating prices is unlikely to be repeated. Central bankers, too, are less tolerant of inflation and have plenty of room to tighten policy, not only through raising interest rates but also withdrawing quantitative easing.
Premature tightening, however, could lead central banks to bring about the stagnation they fear: quashing growth just as the economy is recovering. Last week Jay Powell, chair of the Federal Reserve, said that while bottlenecks and supply chain problems were getting marginally worse, “the historical record is thick with examples of [central banks] underdoing it” and underestimating the need for continued monetary stimulus.
It may be that the period after the second world war is a better historical parallel than the 1970s. Inflation surged in the US and UK at the start of the decade but fell quickly too. As the consultancy Capital Economics pointed out in a research note on Monday morning, the need for millions of demobbed soldiers in Britain to swiftly find new jobs all at once led to labour shortages amid rising unemployment. The end of the pandemic has produced a similar dynamic. Meanwhile, after the Fed made it clear in 1951 that it would not continue its second world war bond-buying programme through the Korean war, price growth was contained in the US after initially rising at the start of the decade.
Either way, central bankers need now to walk a tightrope and keep a close eye simultaneously on economic data, qualitative reports on supply chains and surveys of inflation expectations. Historical circumstances never repeat themselves perfectly and will provide, at best, an imperfect guide to the path of the economy over the years ahead. They do, however, provide an example of the steep costs of taking a mis-step.
Source: Economy - ft.com
