Why stagflation is a growing threat to the global economy
There is a growing debate about whether the inflation that will arise over the next few months will be temporary, reflecting the sharp bounce-back from the Covid-19 recession, or persistent, reflecting demand-pull and cost-push factors.
Several arguments point to a persistent secular increase in inflation, which has remained below most central banks’ annual 2% target for more than a decade. The first holds that the US has enacted excessive fiscal stimulus for an economy that already appears to be recovering faster than expected. The additional $1.9tn (£1.4tn) of spending approved in March came on top of a $3tn package last spring and a $900bn stimulus in December, and a $2tn infrastructure bill will soon follow. The US response to the crisis is thus an order of magnitude larger than its response to the 2008 global financial crisis.
The counter-argument is that this stimulus will not trigger lasting inflation, because households will save a large fraction of it to pay down debts. Moreover, investments in infrastructure will increase not just demand but also supply, by expanding the stock of productivity-enhancing public capital. But, of course, even accounting for these dynamics, the bulge of private savings brought by the stimulus implies that there will be some inflationary release of pent-up demand.
A second, related, argument is that the US Federal Reserve and other major central banks are being excessively accommodative with policies that combine monetary and credit easing. The liquidity provided by central banks has already led to asset inflation in the short run, and will drive inflationary credit growth and real spending as economic reopening and recovery accelerate. Some will argue that when the time comes, central banks can simply mop up the excess liquidity by drawing down their balance sheets and raising policy rates from zero or negative levels. But this claim has become increasingly hard to swallow.
Centrals banks have been monetising large fiscal deficits in what amounts to “helicopter money”, or an application of Modern Monetary Theory. At a time when public and private debt is growing from an already high baseline (425% of GDP in advanced economies and 356% globally), only a combination of low short- and long-term interest rates can keep debt burdens sustainable. Monetary-policy normalisation at this point would crash bond and credit markets, and then stock markets, inciting a recession. Central banks have effectively lost their independence.
Here, the counter-argument is that when economies reach full capacity and full employment, central banks will do whatever it takes to maintain their credibility and independence. The alternative would be a de-anchoring of inflation expectations that would destroy their reputations and allow for runaway price growth.
A third claim is that the monetisation of fiscal deficits will not be inflationary; rather, it will merely prevent deflation. However, this assumes that the shock hitting the global economy resembles the one in 2008, when the collapse of an asset bubble created a credit crunch and thus an aggregate demand shock.
The problem today is that we are recovering from a negative aggregate supply shock. As such, overly loose monetary and fiscal policies could indeed lead to inflation or, worse, stagflation (high inflation alongside a recession). After all, the stagflation of the 1970s came after two negative oilsupply shocks following the 1973 Yom Kippur War and the 1979 Iranian Revolution.
In today’s context, we will need to worry about a number of potential negative supply shocks, as threats to potential growth and as possible factors driving up production costs. These include trade hurdles such as deglobalisation and rising protectionism; postpandemic supply bottlenecks; the deepening Sino-US cold war; and the ensuing Balkanisation of global supply chains and reshoring of foreign direct investment from low-cost China to higher-cost locations.
Equally worrying is the demographic structure in advanced and emerging economies. Just when elderly cohorts are boosting consumption by spending down their savings, new restrictions on migration will be putting upward pressure on labour costs.
Moreover, rising income and wealth inequalities mean that the threat of a populist backlash will remain in play. On one hand, this could take the form of fiscal and regulatory policies to support workers and unions – a further source of pressure on labour costs. On the other hand, the concentration of oligopolistic power in the corporate sector also could prove inflationary, because it boosts producers’ pricing power. And, of course, the backlash against “big tech” and capital-intensive, labour-saving technology could reduce innovation more broadly.
There is a counter-narrative to this stagflationary thesis. Despite the public backlash, technological innovation in artificial intelligence, machine learning and robotics could continue to weaken labour, and demographic effects could be offset by higher retirement ages (implying a larger labour supply).
Similarly, today’s reversal of globalisation may itself be reversed as regional integration deepens in many parts of the world, and as the outsourcing of services provides workarounds for obstacles to labour migration (a programmer in India doesn’t have to move to Silicon Valley to design a US app). Finally, any reductions in income inequality may simply militate against tepid demand and deflationary secular stagnation, rather than being severely inflationary.
In the short run, the slack in markets for goods, labour and commodities, and in some real-estate markets, will prevent a sustained inflationary surge. But over the next few years, loose monetary and fiscal policies will start to trigger persistent inflationary – and eventually stagflationary – pressure, owing to the emergence of any number of persistent negative supply shocks.
Make no mistake: inflation’s return would have severe economic and financial consequences. We would have gone from the “Great Moderation” to a new period of macro instability. The secular bull market in bonds would finally end, and rising nominal and real bond yields would make today’s debts unsustainable, crashing global equity markets. In due time, we could even witness the return of 1970s-style malaise.
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