1970s-style stagflation is now playing out on central bankers’ minds :: InvestMacro

By John HawkinsAnd the University of Canberra

– “Stagflation” is an ugly word to describe an ugly – an unpleasant combination of stagflation and inflation.

The last time the world saw it was in the early 1970s, when oil-exporting countries in the Middle East cut supplies to the United States and other backers of Israel. The “supply shock” of quadrupling the cost of oil has driven up oil prices and dampened economic activity globally.

He thought stagflation had been left behind. But now there is a real danger of that coming back, the central bank warns the world’s central banks.

We may have reached a tipping point, and then inflationary psychology
It spreads and takes root,” says the Bank for International Settlements redundant in the last Annual Economic Report.

“Inflationary psychology” means that expectations of higher prices drive consumers to spend now rather than later, assuming that waiting will cost more. This increases demand, which leads to higher prices. Thus, inflation expectations become a self-fulfilling prophecy.

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The risk of stagflation comes from this inflationary cycle becoming so entrenched that attempts to curb it through high interest rates drive economies into recession.

Global inflation since the nineteenth century

A graph of global inflation since the nineteenth century.
redundantAnd the CC BY

What drives inflation

In addition to its expert staff, the BIS brings together expertise from member central banks, such as the BIS US Federal ReserveThe European Central BankThe Bank of England And the Reserve Bank of Australia. So her views are worth paying attention to.

Its report shows that its experts, like most forecasters, were surprised by how high inflation was.

This is a global phenomenon, which the report attributes to a combination of an unexpectedly strong economic recovery from COVID-19 lockdowns, a continuing shift in demand from services to goods, and supply bottlenecks exacerbated by the shift from “just in time” to “inventory management” just in case. “.

Then there is Russia’s invasion of Ukraine.

The impact of the war on rising prices for oil, gas, food, fertilizer, and other commodities was “inflationary in nature”:

Since commodities are major production inputs, the increase in their cost constrains production. At the same time, the sharp rise in commodity prices increased inflation everywhere, exacerbating the shift that was already in good shape before the outbreak of the war.

The only bright note is that the BIS expects these sharp price increases to be less disruptive than the oil supply shock of the 1970s.

This is because the relative impact of the oil supply shock was greater because economies in the 1970s were more energy intensive.

There is also a greater focus now on containing inflation, with most central banks having a clear inflation target (2% in Europe and the US, 2%-3% in Australia).

Traffic in Los Angeles, 1973. The economies were much more energy consuming than they are now.
Traffic in Los Angeles, 1973. The economies were much more energy consuming than they are now.
Jane Daniels / Wikimedia CommonsAnd the CC BY

What are the biggest dangers?

But the report says the current situation is still very difficult, because increases in food and energy prices are particularly helpful to spread inflationary psychology.

This is because food is bought frequently, so price changes are noticeable. The same applies to fuel prices, which are prominently displayed on large roadside signs.

There is also a risk of a wage-price vortex in many economies – higher prices increase demand for higher wages, which employers forgo at higher prices.

Central banks are facing what RBA Governor Philip Lowe called “narrow road“.

To achieve a “soft landing” they need to raise interest rates enough to bring down inflation. But not enough to cause a recession (and thus stagflation).

How do you avoid a “hard landing”?

The BIS report cites analysis of monetary tightening cycles — defined as interest rate hikes in at least three consecutive quarters — in 35 countries between 1985 and 2018. A smooth landing was achieved in only about half of the cases.

The main factor in the hard landing was the extent of financial weakness, especially debt. Hard-asset economies achieved on average double credit-to-GDP growth before interest rates rose.

This factor contributes to the concerns of the BIS now. As the report notes:

Unlike in the past, stagflation today will occur alongside increased financial weakness, including higher asset prices and higher debt levels, which could amplify any slowdown in growth.

Moreover, the slowdown in labor productivity in China is removing an important boost to global economic growth and curbing global inflation.

But the main lesson of the 1970s is that the long-term costs of doing nothing outweigh the short-term pain of controlling inflation.

This means that governments must limit aid or tax cuts to help people struggling with cost-of-living stress. An expansionary fiscal policy will only make matters worse. Help should be strictly directed to those who need it most.

There is also a need to rebuild fiscal and monetary margins to counter future shocks. This will require raising interest rates above inflation targets and returning (close) government budgets to surplus.Conversation

About the author:

John HawkinsSenior Lecturer, Canberra College of Politics, Economics and Society, University of Canberra

This article has been republished from Conversation Under a Creative Commons License. Read the original article.

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