Stagflation is mainly something from the history book

It started so well this year when the corona measures were lifted. Much faster than most economists expected we all went back to the shopping street and catering. The catch-up growth in the second quarter of this year was spectacular to say the least (more than 6 percent quarter-on-quarter).

Due to this enormous (global) catch-up growth, suppliers are faced with shortages. These were particularly visible in the rising raw material prices and the shortage of chips. The slowdown in the global economy during the corona pandemic and the sudden restart resulted in supply lines being squeezed.

And the most recent development: the sharp rise in gas prices. What do we learn from this? The global economy is not a computer that you turn on and off. It is a complex system of interrelationships that cannot be modeled and that no one really fully understands. With most of the world’s economies reopening, some of these interconnections don’t seem to be running as smoothly as hoped.

The above problems lead to higher inflation, in September inflation in the Netherlands amounted to 2.7 percent. And before you know it, the term ‘stagflation’ is back: a situation where inflation is high, economic growth slows and unemployment rises.

A doomsday scenario, a repeat of the crisis in the 1970s. At the time, an oil crisis led to a sharp rise in inflation. Combined with a slowdown in economic growth and a stimulative monetary policy, inflation and unemployment continued to rise.

The comparison with the current situation is as follows: (1) the higher energy and raw material costs hit the consumer’s wallet, in particular due to the higher energy bill. (2) But also indirectly: the costs for companies rise due to higher energy and raw material prices, which they pass on to the consumer. (3) Consumers are going to spend less and that inhibits growth: in other words, stagflation.

Higher energy bills for consumers alone will not lead to structurally higher inflation above the central bank’s target. (2) is also necessary for this and it remains to be seen to what extent companies can/will pass on the costs to the consumer (see also this piece by my colleague).

But if they do, it will lead to higher prices and curb consumption. Of course, less consumption also leads to less inflation (from the demand side). And that’s exactly where it all started: a very rapid rebound in demand from the reopening of the economy. And with that, the problem is practically solved.

The only danger is that people will come to believe that higher inflation is permanent. This leads to higher wages and companies that in turn pass on wage costs in their products and services – and then inflation is structural in nature. In combination with decreasing growth, you still end up in the stagflation doomsday scenario.

We just have to remember that in the 1970s there was much more going on than just higher inflation due to the oil crisis. The gold standard was unleashed in America (Nixon shock), causing the dollar’s value to halve in a few years. In addition, there was wage indexation at the time. Wages were automatically raised when inflation rose, which – of course by definition – triggers a wage price spiral. At the moment you see that, despite the tight labor market, there is hardly any upward pressure in wages.

But the main difference from the 1970s: monetary policy at the time was not aimed at fighting inflation. The money press was turned on to combat the declining growth.

We now have an independent central bank that operates independently of politics. In addition, the central bank’s main objective is to fight inflation and will intervene at the slightest sign that inflation is structurally above the 2 percent target.

The credibility of this promise is clearly reflected in inflation expectations. Although inflation expectations in the eurozone rose, they remained well below the central bank’s target (2 percent). That is perhaps somewhat higher than the long-term average before the corona crisis, but not entirely surprising given that the actual inflation in September this year (3.4 percent) was far above the historical average of recent years.

So even before structurally higher inflation occurs, central banks intervene. Of course, an interest rate hike will also shock our economic system (I’ve written about that before), but that puts the stagflation scenario off the table.

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