Like a boogeyman to scare children, stagflation is deployed from time to time by economic forecasters to warn how awful things can get if we’re bad. Perhaps that’s why many economists don’t seem to take the threat seriously.
Similar to the response after inflation warnings in 2020, most financial commentators said the threat of stagflation – an unusual combination of a stagnant economy and constant inflation – is low.
But US Federal Reserve Chairman Jerome Powell didn’t sound as confident this week as he has in the past.
“I think we have a good chance of restoring price stability without a recession, without, you know, a severe downturn,” Powell said at a press conference on Wednesday.
“Nobody thinks it’s easy, nobody thinks it’s simple, but there’s certainly a plausible path… to get there.”
Kill the Inflationary Dragon
Powell made it clear that getting inflation under control was the priority, praising his predecessor Paul Volcker, who ultimately slew the inflation dragon, with near 20% interest rates plunging the 1980s economy in a deep recession.
Although we are currently well below those levels, Powell pushed rates up half a percentage point, saying he expected the next two moves to also be half-percentage-point increases. point.
But some worry that the current US central banker has waited too long to raise rates, allowing rising prices to gain a foothold and making recession inevitable, even as North America faces soaring imported inflation. .
A number of prominent American commentators, including former US Treasury Secretary Larry Summers and Economist Mohamed El-Erianwarned that rate hikes, while too late to prevent people from expecting inflation to persist, could themselves push the United States, Canada and the world into recession – and into recession. stagflation.
Recently, this view has spread beyond the worriers, as demonstrated by the normally cautious Conference Board of Canada, which released a report titled Could surging inflation lead to stagflation?explaining how this could happen in Canada.
The strange thing about stagflation, and why it happens so rarely despite repeated scary predictions, is that under normal circumstances two traditional preconditions – inflation and lower GDP growth – are economic opposites and do not often occur together.
The worst of both worlds
As indicated by the Phillips curve, which some say was out of whack even before the pandemic, inflation and economic strength (measured by job creation) are rising together.
But in 1965, Iain Macleod, the British Conservative politician who coined the term, was among those who noticed that the Keynesian rule of thumb was not working.
“We now have the worst of both worlds; not just inflation on one side or stagnation on the other, but both together,” Macleod said. is recorded as saying in the British House of Commons, where he was finance critic.
“We have a sort of ‘stagflation’ situation,” he said. “And history, in modern terms, is indeed being made.”
As with many ideas in economics, there are many arguments about why and how. But when stagflation swept through the United States and Canada in the 1970s, blame was placed on the supply shock caused when OPEC members suddenly demanded an increase in the price of their oil, pushing already high inflation even higher and simultaneously hit the economy.
Never again, oops
“When I was a grad student, all the professors said, ‘Oh, we’ll never see that era of letting the inflation genie out of the bottle again,'” said economist Constance Smith, professor emeritus at the ‘University of Alberta, says ironically.
Like others who lived through this era, she remembers it as “unpleasant” – a term exactly echoed by Powell from her own recollections, as central banks’ repeated attempts to stifle inflation did not managed to convince people that prices would stop rising.
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Smith recalls the constant battles over wage demands that eventually led to cost-of-living adjustments, or “COLA clauses”, written into employee contracts, to ensure that workers’ incomes would not constantly decline due to unpredictable inflation.
Like others who warn of the dangers of returning stagflation, Conference Board of Canada researchers suggest that it’s not just current inflation, but expectations of continued inflation, that will make the difference. .
The Conference Board report draws parallels to the 1970s, and while it says there are differences, “there are similarities between the two eras, implying that stagflation remains a risk to the outlook that does not can be dismissed out of hand”.
History repeats itself – sort of
Using economic modelling, the researchers ran a simulation of the Canadian economy out to 2024, where inflationary expectations embed well beyond 2%.
“The model results remind us how devastating inflation can be for the real side of the economy, as purchasing power quickly erodes,” read the report. “The resulting situation is not unlike the stagflation that occurred in the 1970s, when rising consumer prices fueled wages as workers demanded higher wages to match increases in price.”
The report warns that in addition to stimulative interest rates and high government spending, another similarity to the 1970s is the impact of imported inflation.
Instead of an OPEC-induced oil price hike, we now have the Russian invasion of Ukraine driving up the price of energy and food, continued supply chain distortions from previous waves of the pandemic and, more recently, the closure of Chinese cities, as Beijing tries to coral an outbreak of the Omicron variant.
These forces will likely continue to push prices – and inflation expectations – higher, even as US and Canadian central bankers raise rates in an attempt to stifle domestic demand.
When the latest Canadian jobs numbers are released on Friday, economists predict employment will continue to rise, deepening labor shortages and helping to push up wages.
As Powell noted, strong employment and healthy savings mean the economy can survive the necessary demand destruction. Another way of putting it is that he has a long way to go.
With so many forces pushing prices higher, even as he channels Paul Volcker, the world’s most powerful central banker has made it clear he knows it will be difficult to bring the North American economy to a soft landing – without a hard slowdown and without stagflation. .
“It’s been a series of inflationary shocks that are really unlike anything people have seen in 40 years,” Powell said. “And it’s obviously going to be very difficult.”