As of August 2022, the US Economy has registered negative growth in 2 successive quarters, amplifying the claims that the US has entered a technical recession. Simultaneously, large, and emerging economies are recording the highest levels of inflation since the 70’s, with over 8 out of 10 countries enduring inflation above target, and still rising. Does this mean that Stagflation is inevitable?

What is Stagflation?

The textbook definition is a situation in which there is concurrent slow or negative growth and sustained overall price increases. According to the most basic economics textbooks, and to economists for a very long time, this is a counter-intuitive and very unlikely situation. 

It is widely accepted that there is a trade-off between inflation and unemployment. If inflation is high, the go-to explanation is that the economy is overheating, meaning that demand is rising too quickly for the supply to catch up, forcing general prices up. A recession, on the other hand, usually implies that the economy is performing well below its potential, indicating a weak aggregate demand. Both contradictory, yet happening at the same time. 

This has to do with actual drivers of current output and inflation, and the implications of the corresponding policy responses.

What’s driving inflation and output?

This is still contested. Which goods are prompting inflation, and is it the same everywhere? What’s behind core inflation? Have inflation expectations started to become unanchored? What proportion is demand or supply and/or temporary? Let’s allow ourselves to tell a unified story through the most basic model: Supply and demand. 

Forecasters have had a lot of work to do revisiting growth projections, with the different strains, vaccination, stimulus, global value chains and lockdowns in China, and the most recent Russia-Ukraine war. But certainly, the worst growth forecasts at the start of the pandemic have not materialised. Thanks to massive stimulus packages in large and emerging economies and widespread vaccination, global demand bounced back from the COVID hit faster and earlier than once expected. Exhibit A for inflation.

At this point, central banks with a mandate to control inflation, yet not ignore output, have found themselves performing a balancing act. Luckily, interest rates were extremely low to begin with, but have seen an ever-steeper hike since the start of the year to control the demand-induced inflation, thereby hurting growth. Credibility will be important here, as the greater risk is that high inflation becomes the expectation of markets. 

On the supply side, no such trade-offs are present, but to tackle inflation through supply side interventions is more of an art than a science, and is only reasonably expected to bear fruits in the medium term. For example, there are claims that market power in the US is partially at fault for the magnitude of inflation, and addressing it would cushion the pressure on prices.  Moreover, were Putin’s tantrum to stop, we would also see less pressure in energy and food markets.

So… inevitable?

A short, yet unsatisfying, answer is: Maybe technically yes, but not as bad, hopefully. 

I call it “maybe technically yes” because the US, the main driver of real and financial cycles, meets a simple technical definition of recession, but not a holistic one, as per NBER. The question, then, is when (or if?) the labour market in the US is going to react to the slowing economic pace, and by how much. In the rest of the world, we are already seeing capital fleeing to the Dollar, currencies depreciating, and central banks raising interest rates, with fears of debt crisis in the middle term future.

“Not as bad”, because there are reasons to believe that we are prepared to prevent a scenario like the Great Inflation of the 70s and subsequent Stagflation. Concern is merited, though, given the parallels of current supply shocks to those of 1973 and 1980, a precedent of monetary expansion in both occasions, and due to earlier dismissals of inflation by the FED, which has now backtracked from the position that inflation was temporary and has been forced to respond more heavily than anticipated. Nonetheless, the strong response to the 70s episode of inflation and the following paradigm shift to inflation targeting has meant the Central Banks are much more credible, and market expectations are more easily kept at bay. Moreover, oil prices have increased much less than the quadrupling of the 70s, and are still lower in real terms. Interest rates, on the other hand, have also not increased as sharply, as of August 2022, and are not expected to need to reach double digits in the US in order to contain inflation.

The “hopefully”, comes from the fact that we are relying on no more inflationary shocks to arise, yet they are still a possibility. Tension between the US and China over Taiwan – and the Taiwan situation itself- could bring about more problems for global supply chains, and the prospects of Russia cutting gas supplies to Europe in the upcoming winter has major industrial powerhouses such as Germany already implementing energy rationing plans.

While some level of caution is warranted, a harrowing and prolonged Stagflation is not inevitable, as of yet.

Photo by Victoriano Izquierdo on Unsplash