Are we heading into Stagflation?

There is concern that the current mix of expansionary monetary (near 0% interest rates) and fiscal (lower taxes and increasing government spending with COVID-19) policies will excessively stimulate aggregate demand and lead to inflationary overheating. Add to this negative supply shocks and you have an increase in production costs. This combination could lead to a 1970’s stagflation – rising inflation and unemployment – see graph below. Since the days of stagflation in the US and UK in the 1970’s inflation has been the number one target for central bankers. The main cause of inflation during this period was the price of oil –

  • 1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
  • 1979 – 200%↑ – supply-side – Iran Iraq War
Source: The Economist

US President Jimmy Carter’s attempts to follow Keynes’s formula and spend his way out of trouble were going nowhere and the newly appointed Paul Volcker (US Fed Governor in the 1970’s) saw inflation as the worst of all economic evils. Below is an extract of an interview from the PBS series “Commanding Heights”

“It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon.”

The policy of the time was Keynesian – inject more money into the system in order to get the economy moving again. This was also the case in the UK in the early 1970’s but Jim Callaghan’s (Labour PM in the UK ousted by Thatcher in 1979) speech in 1976 had reluctantly recognised that this policy had run its course and a monetarist doctrine was about to become prevalent. Below is an extract from the speech.

“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment. That is the history of the last twenty years”

With this paranoia about inflation central bankers began to implement a monetary policy targeting inflation in the medium term. In NZ the Reserve Bank Act 1989 established “price stability” as the main objective of the RBNZ. “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (originally 0-2%) – measured by the percentage change in CPI. Around the world central banks were adopting a more independent approach to policy implementation and with targeting inflation a new prevailing attitude seemed to be like an osmosis and suggesting that low prices = macro-economic stability as well. Also, raising interest rates is an unpopular political move and governments could now blame the central bank for this contractionary measure.

So are we now concerned that we will be entering another period of stagflation? Like the 1970’s we do have a supply-side issue (although not oil based) and expansionary demand side. The following are concerns:

Growth – Supply bottlenecks have led to growth slowdown in the US, China, Europe and the other major economies. Furthermore the Delta variant is increasing production costs as well as impacting the labour supply and ultimately reducing output growth. There is also the problem of moral hazard in that generous unemployment benefits are reducing the incentive to find work.

Demand Side – Excessive fiscal stimulus for an economy that already appears to be recovering faster than expected and it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay.

Supply Side – Again Delta is impacting many global supply chains, ports and logistical systems. Shortages of semi-conductors impacts the car industry as well as electronic goods thus increasing in inflation. Will the global supply side be positively influenced by better use of technological innovation in artificial intelligence and the return to normality on global supply distribution networks. Also will demand pressure eventuate especially when the threat of unemployment is ever present.

Although there are negative price shocks which could deter potential growth, expansionary fiscal and monetary policy could still increase the inflation rate. The resulting wage-price spiral could lead to astagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflationary debt crisis will continue to loom over the medium term.

Source: The Stagflation Threat Is Real – Nouriel Roubini – Project Syndicate 30th August 2021

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