What stagflation means for the West and the Middle East
Inflation is a leading contender for the economic term of the year so far, but now it is being challenged by the word recession. This reflects the prospect of stagflation — a period of inflation and slow growth — in an uncomfortable echo of the 1970s, when steep oil price rises led to inflation and recession in oil importing countries. Central bankers must find a path through these conflicting pressures, while investors now face bond routs and wobbly equity markets.
Several factors have pushed consumer price inflation in the West to levels not seen in four decades. Aggressive monetary interventions during the pandemic, often accompanies fiscal largesse, delivered a tsunami of cash, which triggered extraordinary stock and property price rallies. Disruptions to all manner of supply chains created further pressures, due to bottlenecks and higher transportation costs. Commodity markets have been upset by the Ukraine war and sanctions on Russia. US headline inflation rose to a 21st century record of 8.5 percent in March following a 1.2 percent increase from the previous month.
Large parts of current inflationary pressure are temporary. The COVID-19-related disruptions and other external shocks cannot last forever. But there is more to the story. US core consumer price inflation, which excludes volatile energy and food prices, hit an annual 6.5 percent in March. While markedly below the headline rate, this is a very high reading after more than two decades of annual price rises of around 2 percent.
In a tight labor market, this matters. The prospect of a wage-price spiral is distinct, with US salaries rising by more than 4 percent a year. To some extent, this may produce its own cure by attracting more people back into the workforce. Some relief may also come from technology-driven productivity gains.
But should this wage inflation persist, it will feed into higher prices.
The longer-term outlook betrays growing anxiety. US inflation expectations over the coming 10 years have risen to more than 3 percent, the highest in two decades. The fiveyear inflation expectation in the eurozone is about to hit 2.5 percent. Both well above the historical norm, and are higher than the inflation targets of their respective central banks. When inflation is not stable, it can easily begin to accelerate.
As complex and multi-faceted as the current inflation problem is, central banks are approaching it with their standard toolkit, starting with unwinding pandemic-era interventions. But the response is arguably delayed and potentially all the more potent for that. The real question is whether this spells the end of the “lower for longer” interest rate era.
The fight against inflation is happening on multiple fronts. The hawkish turn in US central bank rhetoric is an attempt to reshape market expectations before it is too late. The Federal Reserve’s planned monthly balance sheet reductions of $95 billion will give rise to a new capital market environment.
Already, more than $10 trillion worth of sub-zero debt has turned positive as bond prices have tumbled, leaving less than $3 trillion in negative territory. This will shift investor preferences in favor of less risky products while increasing the cost of highyield debt.
The International Monetary Fund has warned of challenges for emerging market countries that boosted their lending from less than $65 trillion in 2016 to almost $100 trillion by the end of last year. With the growth of these nations projected to slow to 3.8 percent, the global outlook will moderate. The conflict in Eastern
Europe and lockdowns in China will have a similar effect.