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Measures To Prevent Stagflation

A recent data set suggests that the global economy is signaling stagflation , that strange 1970s-style combination of rising inflation and stagnant growth. Those who perceive it – though they are still too few – fall into two broad categories. Some see the phenomenon as temporary and rapidly reversible. Others fear it will lead to a renewed period of unsatisfactory growth, but this time with alarmingly high inflation.

But a third scenario, which draws on these two visions, may well be the most feasible. Stagflationary winds are more likely to be part of the impending trajectory of the global economy rather than a structural factor. But how policymakers travel this path will have important implications for economic well-being, social cohesion, and longer-term financial stability.

The much-needed global economic recovery has recently lost momentum as growth in its two main locomotives, China and the US, fell short of expectations. The more contagious Delta variant of the coronavirus slowed consumption in summer in some sectors, such as leisure and transport, while affecting production, particularly in industry. Labor shortages are becoming more widespread in a growing number of advanced economies. Add to that a shortage of shipping containers and the ongoing realignment of supply chains, it should come as no surprise that the headwinds for a strong and sustainable global recovery are accompanied by higher and persistent inflation .

Higher inflation puts pressure on those central banks that want to maintain exceptionally loose monetary policy. At the same time, a slowdown in economic growth presents a problem for central banks that are more inclined to reduce stimulus measures. All of this also threatens to erode support for much-needed fiscal and structural policies to boost productivity and long-term growth potential.

Some economists, and most politicians, believe that current stagflationary trends will soon be weakened by a combination of market forces and changes in human behavior. They point to the recent drops in lumber prices, previously on the rise, as an indicator of how competition and increased supply will cool inflation , especially now that the virus recedes. And they take comfort in the multiple signs of booming business investment.

Others are more pessimistic. They argue that domestic demand will suffer due to reductions in worker aid plans, and recall that direct aid to the most affected sectors is in retreat. They are also concerned that the savings accumulated during confinement are not being released as quickly as expected.

On the supply side, stagflation pessimists welcome increased business investment, but fear its benefits will not come quickly enough, especially because of supply chain problems. In their view, supply shocks will therefore persist much longer and central banks will be delayed in offering the necessary policy response.

I suspect none of these scenarios are likely to dominate the future. But they will influence the alternative that ends up materializing.

In theory, policy makers are prepared to respond to stagflation, and the US would lead by making faster progress on certain areas. For example, the Fed is already rethinking some of its ultra-lax monetary policy and Congress is allowing the Administration of President Joe Biden to advance its plans to improve productivity and longer-term growth by boosting public investment. For their part, international authorities are better coordinated to avoid worrying situations in the markets.

These measures would lead to a drop in inflationary pressures, faster and more inclusive growth, and genuine financial stability. And such a desirable outcome is achievable if the necessary policy response is developed in a comprehensive and timely manner.

If there is no such response, the supply-side problems will be more structural in nature , and therefore will last longer than expected. The resulting inflationary pressures will be amplified by the higher wages that many companies will have to offer to attract workers they do not have today and retain those they already have. If central banks delay in their response, price expectations run the risk of destabilizing, multiplying volatility.

In that case, the anti-inflation measures would be accompanied by lower and less inclusive growth , especially if the Biden Administration’s plans remain stuck in Congress (something that would be more feasible in the high inflation scenario). Instead of prolonged stagflation, the global economy would repeat what it experienced after the 2008 global financial crisis: low growth and low inflation.

The recent emergence of stagflationary trends serves as a timely reminder of the urgent need for comprehensive economic policy action. The sooner such a response materializes, the greater the likelihood of anchoring economic recovery, social welfare and financial stability. But if policy makers delay, the world will return to the previous “new normal” of low economic growth, non-existent social cohesion and destabilizing financial volatility.