Stagflation - are we thrown back to 1970s?

Stagflationary tendencies are gaining strength in the global economy after many decades. 1970s was an era of weak economic growth, rampant inflation and lousy stock market performance. Luckily many things have changed since the 1970s.

The initial economic impact of the coronavirus pandemic and its mitigation strategies was a rapid fall in economic activity and dampening price pressures witnessed last year. Expansionary fiscal measures launched by the governments around the world were aimed at supporting economic activity, which in turn adds to price pressures. Accommodating monetary policy measures had the same goal and worked through looser financial conditions to the households and firms.        

The gradual easing of the pandemic situation and consequent opening of the economies led to severe bottlenecks in international supply chains as well as in labour markets last spring. Increases in prices of materials, intermediate goods and logistics costs pushed producer prices up and along with ultra-loose policy stance eventually lifted consumer price inflation to levels seen last time just before the global financial crisis of 200809.

Inflation has hovered around 5% since May in the US and has recently exceeded 3% in the Eurozone and in the UK. This is obviously well above the common 2% inflation target of the central banks. As long as the economic recovery from the lows of the pandemic has been strong, the surge in inflation has raised relatively little concern among pundits and market participants.

Central bankers have repeatedly commented that the inflation spike is temporary, and that it will fade away relatively rapidly. The tone in central bank communications has, however, started to change. Federal Reserve Chairman Jerome Powell admitted last week in ECB’s policy panel that supply chain problems will stretch into 2022 and inflation will stay higher longer than the Fed had assessed.

Initially, there were good reasons to argue for the temporary nature of recent inflation developments. The causes for the price increases were clearly related to the reopening of the economies after shutdowns. However, the longer the high inflation persists, the bigger will the risk of prolonged inflation become. This self-fulfilling feature of inflation depends on the formation of inflation expectation of both firms and households. If inflation is expected to remain high, then households and firms will change their behavior in a way which eventually produces higher inflation.

The global economic recovery after the lockdowns has been surprisingly strong. Economic indicators from recent months have, however, shown some weakness especially in Europe and in China. The question is, will surging prices choke off global economic momentum more effectively than we expected?

Stock markets have retreated since early September, as inflation worries have intensified along with surging energy prices, the uncertainty around the Chinese real estate giant Evergrande’s future has intensified and the debt ceiling negotiations recurring in the US once again threaten to push the US government towards an unprecedented debt default.

So, now in the fall of 2021 a new worry for investors has emerged – stagflation – the co-existence of sluggish economic growth and high inflation. The term was coined in the 1970s to describe the stagnating industrial economies plagued by high and volatile inflation. The two energy crises during the same decade sent the prices of fossil fuels skyrocketing. Central banks were weak and in the hands of the politicians focused on fostering employment rather than securing price stability. Labour unions’ bargaining power was strong and wage indexation was wide-spread, which basically guaranteed the emergence of vicious price-wage spiral.

And most importantly, 1970s was an extremely lousy decade for investors. Stock indices ended the decade being close to the levels at the start of the same decade. And this was the era of high inflation, which led to e.g. S&P 500 annual real total return to settle in the negative territory. No wonder comparisons of the current situation to ‘70s cause uneasiness among investors.

Should we be worried about the possible re-emergence of stagflation? Yes and no, would a two-handed economist say.

There are clearly stagflationary tendencies in the world economy with inflation running well above central banks’ inflation targets and global growth settling to a lower level after the speedup from the lows of the pandemic.

In the short run the combination of rampant inflation and weaker growth will put pressure on the firms’ earnings developments. The Q3 earnings season is about to begin, and the focus will be in comments on the cost developments and supply disruptions. The following Q4 earnings season early next year might then reveal how well the top line of the firms in various industries will hold up in the face of weaker economic growth.

Despite recent weakness in the global stock markets the equity valuations are still high relative to history. The combination of stretched valuations, pressures on both firms’ costs and top line, and the fact that central banks are ready to start winding down monetary policy measures designed to support economic activity during the pandemic, makes stock markets sensitive to negative surprises. So, it’s reasonable to expect continued nervousness and volatility in the stock markets in the near term.

But the real question is, will history repeat itself so that we are thrown back to 1970s? Well, luckily many things have changed since the ‘70s. Both central banks and labour markets look very different.

In the 1990s, the modern central banks with more independence from the political process and with clearer mandates to focus on price stability were established as a response to the negative experiences of the former decades. In the labour markets, wage indexation has been abolished and the workers’ bargaining power in general has diminished due to globalization.

Recent changes in the monetary policy strategy of both the Fed and the ECB have increased – at least temporarily – the tolerance of higher inflation. Even though the central banks are now allowing inflation to run well above the target, it is quite clear, that they are ready to step on the brakes if needed. So, the worries of a prolonged stagflationary period are overstated.

The braking will happen. But due to changes in monetary policy strategies, it will be a late braking, which might cause macroeconomic and financial instability down the road.

October 7, 2021
Anssi Rantala
Senior Advisor / Chief Economist