“Stagflation” is a bad word for an ugly situation – the unpleasant combination of economic stagnation and inflation.
The last time the world saw it was in the early 1970s, when oil-exporting countries in the Middle East cut off supplies to the United States and other supporters of Israel. The “supply shock” of a fourfold increase in the cost of oil has driven up many prices and dampened economic activity globally.
It was thought that stagflation had been abandoned. But now there is a real risk that it will come back, the central bank warns for central banks around the world.
By “inflationary psychology” it means that higher price expectations lead consumers to spend now rather than later, on the assumption that waiting will cost more. This increases demand, driving up prices. Thus, inflation expectations become a self-fulfilling prophecy.
The danger of stagflation comes from the fact that this inflationary cycle becomes so entrenched that attempts to curb it with higher interest rates push economies into recession.
Global inflation since the 19th century
What fuels inflation
In addition to its own experts, the BIS brings together the expertise of its member central banks, such as the US Federal Reservethe European Central Bankthe bank of england and Reserve Bank of Australia. His points of view therefore deserve attention.
Its report clearly indicates that its experts, like most forecasters, were surprised by the magnitude of the rise in inflation.
It’s a global phenomenon, which the report attributes to a combination of a surprisingly strong economic rebound from the COVID-19 lockdowns, a sustained shift in demand from services to goods and supply bottlenecks. bottlenecks exacerbated by a shift from “just in time” to “just in case” inventory management.
Then there is Russia’s invasion of Ukraine.
The war’s effect on rising prices for oil, gas, food, fertilizer, and other commodities has been “inherently stagflationary”:
Since commodities are a key production input, an increase in their cost limits production. At the same time, soaring commodity prices spurred inflation everywhere, exacerbating a shift that was already well underway before the war began.
The only positive note is that the BIS expects these price spikes to be less disruptive than the oil supply shock of the 1970s.
This is because the relative impact of the oil supply shock was greater due to the economies of the 1970s being more energy intensive.
There is also much more emphasis now on controlling inflation, with most central banks having a clearly defined inflation target (2% in Europe and the United States, 2% to 3% in Australia).
What are the biggest dangers?
But the current situation remains very difficult, the report says, as increases in food and energy prices are particularly conducive to the spread of inflationary psychology.
This is because food is purchased frequently, so price changes are noticeable. The same goes for fuel prices, which are displayed prominently on large road signs.
In many economies, there is also the risk of a wage-price spiral – in which higher prices lead to demands for higher wages, which employers then pass on in higher prices.
Central banks are facing what Reserve Bank of Australia Governor Philip Lowe called “narrow path“.
To achieve a “soft landing,” they need to raise interest rates enough to bring inflation down. But not enough to cause a recession (and therefore stagflation).
How to avoid a ‘hard landing’?
The BIS report cites an analysis of monetary tightening cycles – defined as interest rate hikes for at least three consecutive quarters – in 35 countries between 1985 and 2018. A soft landing was only achieved in about half of the cases.
The scale of financial vulnerabilities, particularly debt, was a key factor in the hard landing. Economies experiencing hard landings had on average doubled the growth of credit to GDP before the interest rate hikes.
This factor now contributes to BIS concerns. As the report notes:
Unlike in the past, stagflation today would occur alongside heightened financial vulnerabilities, including stretched asset prices and high debt levels, which could amplify any slowdown in growth.
In addition, slowing labor productivity in China is removing a significant boost to global economic growth and moderating global inflation.
But a key lesson from the 1970s is that the long-term costs of doing nothing outweigh the short-term pain of controlling inflation.
This means that governments must limit aid or tax cuts to help people facing the pressure of the cost of living. An expansionary fiscal policy will only make matters worse. Aid must be strictly targeted to those who need it most.
There is also a need to rebuild monetary and fiscal buffers to deal with future shocks. This will require raising interest rates above inflation targets and returning public budgets (almost) to surplus.