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What is Stagflation? Is the World Economy Heading Towards Stagflation in 2021?

Oct 9, 2021 9:56 AM 5 min read

Even as vaccination rates pick up steam and countries talk more confidently of a post-pandemic future, new cracks have begun appearing on the delicate canvas that is the world economy.

Global supply chains are in gridlock. The shipping industry is struggling to meet surging demand. Crude oil prices are touching new highs. Natural gas is becoming increasingly expensive, sparking fears of winter blackouts in Europe. China's energy crisis threatens to affect its post-COVID recovery, already endangered by the Evergrande "Lehman moment". India is running out of coal, casting doubt on electricity supply and the country's green transition. The US is adding fewer jobs than expected. The semiconductor shortage threatens to increase the price of everything from iPhones to EVs. Food prices are jumping. Western companies are struggling to fill vacancies amid labour shortages. Inflationary fears are hovering over every central bank. And fiscal and monetary stimulus measures put in place to fight the coronavirus recession remain in place.

We can do a deep-dive into each of these developments separately. But that would be a tedious recipe for a depressing weekend! Instead, let's focus on the new menace on the horizon - a possibility that can arise out of the combination of all the above factors: stagflation.

What is Stagflation?

When an economy is growing at a healthy pace and the unemployment rate is low, inflation tends to inch upwards. This is because there is more money in the system and thus more demand for the same goods and services, driving their prices up.

The converse is also possible. An economy in recession and with a high unemployment rate sees less disposable incomes and lower levels of discretionary spending. This stagnates or drives down the prices of goods and services, which pushes the inflation rate down.

Stagflation, or recession-inflation, is a rare exception to these scenarios. It is a situation where there is high inflation, high unemployment and slow economic growth - all at the same time. The perfect storm, as it were.

Historically, the term "stagflation" (which is a combination of "stagnation" and "inflation") can be traced back to a speech made in the British Parliament in 1965, when future Chancellor of the Exchequer Iain Macleod used it to describe the unique economic crises plaguing his country at the time. He rightly noted it as an oddity: "...history, in modern terms, is indeed being made."


Ghost of Stagflation Past

Stagflation in the 1970s was the result of a series of complicated developments. At the beginning of the decade, the Richard Nixon White House imposed wage and price controls to stem rising inflation at home and, significantly, ended the gold standard, which dismantled the Bretton Woods system and led to the current regime of free-float fiat currencies. The so-called "Nixon shock" was a tectonic alignment of international finance.

And it was terrible timing. Because only two years later in 1973, OPEC severely constrained global oil supply to protest US support to Israel. Crude prices naturally skyrocketed, doubling in a matter of months. In 1979, the Iranian Revolution and the Iran Hostage Crisis happened, further exacerbating the oil supply shock. This drove up the prices of everything else (aka cost-push inflation).

Now, let’s indulge in a little bit of theory. Until the 1970s, the prevailing macroeconomic philosophy - Keynesianism - held that unemployment and inflation are inversely related. The 1970s obviously put this belief into question.

Enter, the monetarists. Specifically, Milton Friedman, who argued that "inflation is always and everywhere a monetary phenomenon". He believed that inflation could have been controlled better had central banks (the Federal Reserve, in this case) been more aggressive in their response i.e. Had they increased interest rates to curb money supply in the economy and thus tame inflation.

Which is what the Fed finally resorted to after 1979, when the federal funds rate was increased from below-5% levels to nearly 20% by 1981. This was the beginning of the era of inflation-targeting, the transformation of central banks into monetarist inflation-fighting organisations. (Incidentally, this era ended last year, when the Fed decreed it would allow rates to remain at record low levels and tolerate “moderate” inflation to support growth.)

Domesticating inflation was the top agenda of central bankers in the decades that followed. The 2008 economic crisis changed that. Suddenly, reducing unemployment became the talk of monetary town again. Consistently low interest rates in the developed world encouraged more fiscal adventurism and also enabled the vast stimulus infused into markets since the start of the pandemic.

Which brings us to today. The eerie parallels to the 1970s world economy - tenuous growth, high oil prices, supply shocks and a fickle labour market - have brought back the old ghost of stagflation to haunt policymakers and economists.


All Smoke, No Fire?

Fears about stagflation 2.0 are well-founded. Because curbing stagflation involves reducing inflation while creating jobs, a delicate balance to maintain. After all, it’s difficult to curb money supply by extremely high levels without inducing a recession and sparking popular unrest.

But that doesn’t mean stagflation is an inevitability. Many observers have downplayed fears, arguing that the parallels to the 1970s are limited. Take the US. During that decade, it saw 9% unemployment, double-digit inflation and a contracting economy. As of August 2021, however, the country’s unemployment rate was at around 5%, inflation at around 4% and the economy continues to grow, the low base effect notwithstanding.

What’s more, decades of inflation-targeting have borne fruit. In fact, before the pandemic, central banks in the West were actually trying to induce inflation, which was at damagingly low levels for years thanks to the near-zero or even negative interest rate environments that were propped up in the wake of the Great Recession.

The IMF contends that, despite fears, the global economy is slated for healthy near-term growth. It predicts consumer prices in advanced economies to peak at 3.6% before slowing to 2% in 2022.

Moreover, central bankers today are more proactive than their demure, hesitant predecessors in the ’70s. Budget deficits around the world are actually forecast to shrink next year. And the world economy today is drastically different to the one four decades ago. There are more participants in the globalised structure. More trade. More liberalisation. More interdependency.

Which means that even if the world is flirting with stagflation, the challenge ahead of us would likely be nothing like the one before.

But whether a 2020s stagflationary crisis would be as severe as the one in the 1970s, if not worse, is anyone’s guess.


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