Through Nicholas LarsenInternational banker
“Six months ago we were really worried about a slowing recovery and very high prices for some commodities and now I think we’re much more concerned about general stagflation which brings back really bad memories of the mid 1970’s and the lost decades ,” confirmed Indermit Gill recently. And, using the dreaded “sword word,” the World Bank chief economist reiterated what much of the world is now fearing: One of the most dreaded macroeconomic scenarios will hit us sooner rather than later.
It is clear that the global economy is now facing monumental disaster, both caused and exacerbated by accelerating inflation, which has reached double digits in some major economies in recent months. And with central banks around the world now scrambling to stem runaway prices through steep interest rate hikes that will no doubt worsen conditions for both economic growth and jobs, the risk of an extended period of stagflation is now become tangible. And politicians know it. “We are experiencing supply chain problems, production bottlenecks and price increases that we haven’t experienced in decades,” said Deputy Federal Minister of Finance Florian Toncar in mid-September. “Growth forecasts have been revised downwards noticeably in recent months, while inflation forecasts have been revised upwards more and more…. In this environment, the risk of stagflation increases.”
Some analysts simply limit the definition of stagflation to a combination of high inflation and low economic growth, while others add rising unemployment to the mix. In any case, stagflation is clearly an undesirable situation for an economy to find itself in, especially given that efforts to alleviate one measure tend to have the unintended consequence of tightening one of the other measures. It’s also very rare, largely because high inflation typically results from a period of accelerating growth when demand for goods and services is growing, rather than a slowdown, as has been the case so far in 2022. We are now witnessing persistent inflation due to rising global energy and food prices, as well as a seismic surge in money supply from quantitative easing programs that have created too much money chasing too few goods. As a result, prices have continued to rise while incomes have remained broadly flat – or even fallen in some cases.
Given this predicament, today’s US economy is eerily similar to that of the 1970s, when protracted stagflation was last seen. Back then, a series of oil embargoes by the Organization of the Petroleum Exporting Countries (OPEC) in 1973 sent crude oil prices soaring, causing inflation – which was already on the rise after a period of expansionary monetary policy initiated by the US Federal Reserve (the Fed) – to start the climb. Gross domestic product (GDP) growth also slowed significantly during this decade, with the US economy experiencing two major recessions before a third hit in 1980; US inflation peaked at over 14 percent at the turn of the decade; the Federal Funds Rate (FFR) hit 20 percent to try to quell that inflation; and the unemployment rate reached 10.8 percent at the end of 1980.
So are we experiencing a similar period of stagflation today? Well, we certainly saw inflation accelerate for much of 2022. And economic growth, as measured by GDP, has also slowed. “Last year growth was 5.7 percent. This year it should be 2.9 percent. At the same time, inflation rates are currently at levels not seen in years,” World Bank project coordinator Raka Banerjee noted in July. But fortunately, unemployment remains low in most major economies for now. In the United States, inflation was 8.3 percent in August, while quarter-on-quarter growth declined 0.6 percent in the second quarter (Q2). In the eurozone, on the other hand, inflation rose to 9.1 percent, while quarterly growth was just 0.8 percent over the same period. But in both cases, unemployment has remained low — the euro-zone jobless rate is at a record low of 6.6 percent in July, while the US jobless rate hit 3.5 percent in July, its lowest level in more than two years, before it in August slightly up went 3.7 percent.
So we may not be experiencing stagflation yet. Most worrisome, however, is that interest rates will almost certainly continue to rise — and sharply — for the remainder of the year. In fact, hikes of 100 basis points are not out of the question given persistently high inflation. And since central banks are primarily dependent on maintaining price stability at moderate target levels, they are increasingly desperate to bring down inflation by raising interest rates significantly. The result of this desperation? Recession. The demand destruction caused by such aggressive monetary tightening will undoubtedly lead to business closures; massive job losses across the board are to be expected.
And it seems central banks have resigned themselves to sacrificing those jobs if it means inflation can be moderated over the long term. Before people like the Fed can even consider halting their rate-hiking cycles, the economy needs to tick a few boxes, including inflation of around 2 percent (or whatever their respective targets dictate), ideally sustained slow growth (but even negative growth will do). be admitted) and a modest rise in unemployment. “We have to get inflation over with,” Fed Chair Jerome Powell recently conceded after raising the federal funds rate by 75 basis points to 3-3.25 percent, the highest, at the September Fed meeting As of 2008. “I wish there was a painless way to do this. There is not any.”
But how high will unemployment ultimately rise? “The U.S. job market is on the upswing and showing little sign of contraction, making a 1970s-style stagflation scenario far less likely,” wrote Joseph H. Davis, Vanguard’s chief global economist, in an article for CNN published on March 20 September 2nd was released. “Much of the demand for labor reflects a high need for specific skills across a range of industries, and the labor supply remains insufficient for existing jobs even with slower growth. Even if companies cut job vacancies by 20 percent and layoffs increase by 20 percent, the US labor market will still be relatively tight, according to our own analysis. And some companies may be reluctant to lay off workers in this coming recession, fearing they may not be able to rehire them.”
The worst-case scenario, perhaps, is if inflation remains stubborn – that is, stubbornly high and difficult to bring down despite sharp rate hikes. “The worst thing is that you get stuck in the stagflation of the 1970s. If inflation solidifies in expectations, that’s a very bad thing,” Brad DeLong, a professor at UC Berkeley, recently told Fortune magazine. DeLong also noted that gasoline and energy prices would be the key determinants of whether inflation would become entrenched. “Whether the expectations solidify and we get a problem from the 1970s really depends on how energy prices develop. Inflation expectations are always driven by what people see at the pump.”
According to Moody’s, the potential for prolonged stagflation “remains a concern that will persist until the current inflationary spurt has finally subsided.” The rating agency noted that a stagflationary economy would be characterized by unrestrained inflationary expectations, a much more aggressive withdrawal of monetary stimulus and persistently weak economic growth, while elevated energy prices and commodity costs would hurt earnings in all sectors including airlines, autos, chemicals, metals, forest products, Shipping, construction and manufacturing companies. Moody’s also forecast on September 26 that the probability of a US recession in the next 12 months is currently 59.5 percent.
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