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Stagflation – a serious risk scenario

October 19, 2021
in Markets
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Stagflation – a serious risk scenario

The global economic recovery is still underway despite strong turbulence. How long will it last?

In recent months, the risk of stagflation (the simultaneous occurrence of economic stagnation and inflation) has increased. Without the pandemic, output would be higher and inflation lower: bottlenecks in production and logistics have slowed economic activity and caused prices in the goods sector to rise sharply.

In addition, the sharp rise in energy prices has reduced consumers’ purchasing power. There were also bottlenecks on the labor market: The shift in consumption has shifted the need for labor from one sector to another, thus increasing unemployment, as workers cannot be replaced as easily.

In cyclical terms: no stagflation

The post-Covid recovery threatens to be short-lived, while inflation remains high in the long run. Are we now facing stagflation? If the phase of bottleneck-induced high inflation rates lasts longer than originally assumed, there is an increased risk that long-term inflation expectations will also rise: A so-called wage-price spiral would then be set in motion.

To prevent this negative scenario, more and more central banks are reducing the ultra-expansive monetary policy stance. The aim is to anchor inflation expectations firmly at the central bank’s inflation target. As a result central banks are raising key interest rates faster than expected toward an interest rate level that is neutral for the economy. As long as central banks remain successful in doing so, i.e. inflation expectations do not rise, the current above-average inflation rates will disappear as soon as the bottlenecks dissipate. Then the economic recovery toward full employment could also proceed more smoothly.

The risk of immediate stagflation has increased, but is still manageable. In the long term, however, structural inflation risks have increased for two reasons: Deflationary forces are diminishing and inflationary forces are increasing

Deflationary forces are disappearing

Over the past 25 years, inflation rates have fallen significantly for two main reasons: globalization, especially the opening of China, and the growing working-age population. However, these two effects are increasingly weakening.

In more and more countries, the working-age population is shrinking. Many countries are trying to compensate for this trend by increasing the labor force participation rate. However, this is not succeeding everywhere: in the USA, for example, the labor force participation rate is on a downward trend. Higher productivity growth could theoretically also offset the effect of the proportionally shrinking working-age population.

But in fact, productivity growth has been declining for years, despite technological advances in digitization. Less work means a more difficult bargaining position for employees and ultimately pressure on the wage-price spiral. It is not only demographic developments that could lead to higher inflation. Several studies point to the stagflationary influence of climate change: without climate change, production and the price level would also be lower.

Inflationary forces on the rise

On the monetary and fiscal policy side, the pattern of thinking and behavior has changed. With inflation rates in many cases below the central bank’s respective target over the past 10 years, monetary policy has remained looser for longer overall compared to the past.

On the fiscal side, there are indications that the current phase of high budget deficits will not be followed by austerity: The recovery phase should not be jeopardized. Central banks and finance ministries are called upon not to tighten the reins too quickly, but not too slowly either. Switching to a restrictive course too soon would lead to a low-growth environment. However, if full employment is eventually reached and policymakers are too slow in withdrawing the expansionary course, there is a risk of the economy overheating. Inflation would then rise. But how would central banks respond?

Conflicting objectives

Central banks are explicitly or implicitly confronted with several objectives: Keeping inflation at a low level in the medium term and achieving full employment, not jeopardizing financial stability and public debt dynamics (by raising interest rates sharply), and supporting the fight against climate change.

What would be the answer to possible trade-offs? Key interest rates could be raised too little so as not to jeopardize financial stability and public debt dynamics. Inflation could then get out of hand, and ultimately the central bank would react too late to inflation and stifle economic growth with the necessary rate hikes. This scenario could lead to a structural stagflationary environment.

Conclusion

The pandemic has led to higher-than-expected inflation expectations. In the most likely scenario, this is a temporary phenomenon: however, an inflation problem is a serious risk scenario in the medium term.

Important legal information:

Forecasts are not a reliable indicator of future performance.

Source
Stagflation – a serious risk scenario is written by Stephanie Clam Martinic for blog.en.erste-am.com

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