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Business News/ Opinion / Views/  Keeping stagflation in check will be a global challenge
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Keeping stagflation in check will be a global challenge

The supply shock of the Ukraine crisis has upped stagflationary risks earlier stoked by ultra-loose economic policies and we now see major fiscal and monetary policies diverge precariously

Photo: HTPremium
Photo: HT

The global economy has suffered two negative supply-side shocks, first from covid and then from Russia’s invasion of Ukraine. War disruptions have come with higher inflation as its short-term effects on supply and commodity prices have combined with the consequences of excessive monetary and fiscal stimulus across advanced economies. Putting aside the war’s profound geopolitical ramifications, the immediate economic impact has come in the form of higher energy, food and industrial metal prices. Together with supply-chain disruptions, this has worsened the stagflationary conditions that emerged during the pandemic.

A stagflationary negative supply shock poses a dilemma for central bankers. They must anchor inflation expectations, so they need to normalize monetary policy quickly, even though this will lead to a further slowdown and possibly a recession. But since they also care about growth, they need to proceed slowly, even if that risks de-anchoring expectations and setting off a wage-price spiral.

Fiscal policymakers also face a difficult choice. Given the supply shock, increasing transfers or reducing taxes is not optimal, as it prevents private demand from falling in response to the reduction in supply. Thankfully, EU governments spending more on defence and decarbonization can count these forms of stimulus as investments that would ease supply bottlenecks over time. Still, any additional spending will increase debt on top of the excessive response to the pandemic.

As covid has receded, governments have embarked on gradual fiscal consolidation and central banks have begun policy normalization to rein in price inflation, but the Ukraine war has introduced new complications.

Fiscal-monetary coordination defined the pandemic response. But now, while central banks have stuck with their newly hawkish stance, fiscal authorities have enacted easing policies (such as fuel-tax relief) to soften the energy blow. Coordination seems to have given way to a division of labour, with central banks addressing inflation and legislatures tackling growth and supply issues.

In principle, most governments have three economic objectives: supporting economic activity, ensuring price stability and keeping long-term interest rates or sovereign spreads in check through persistent monetization of public debt. An additional goal is geopolitical: Putin’s invasion must be met with a response that both punishes Russia and deters others from considering similar acts of aggression. The tools in use are monetary policy, fiscal policy and regulation. Until recently, re-investment policies and flight-to-safety capital flows had kept long-term interest rates low by maintaining downward pressure on ten-year Treasury and German bond yields.

Owing to this confluence of factors, the system has reached a temporary equilibrium, with each of the three objectives being partly addressed. But recent market signals, such as a significant rise in long-term rates and intra-euro spreads, suggest that this policy mix will become inadequate, producing new disequilibria.

Additional fiscal stimulus and sanctions on Russia may feed inflation, partly defeating monetary policy efforts. Moreover, central banks’ drive to tame inflation via higher policy rates will become inconsistent with accommodative balance-sheet policies, and this could result in higher longer-term interest rates and sovereign spreads. Central banks will have to keep juggling the incompatible objectives of taming inflation while also keeping long-term rates low. And all the while, governments will continue to fuel inflationary pressures with fiscal stimulus and persistent sanctions.

Over time, tighter monetary policies may cause a growth slowdown or outright recession. But another risk is that monetary policy will be constrained by the threat of a debt trap. With private and public debt levels at historic highs as a share of GDP, central bankers can take policy normalization only so far before risking a financial crash in debt and equity markets.

At that point, governments, under pressure from disgruntled citizens, may be tempted to come to the rescue with price and wage caps and administrative controls to tame inflation. These measures have proven unsuccessful in the past, not least in the stagflationary 1970s, and there is no reason to think that this time will be different. If anything, some governments would make matters even worse by, say, re-introducing automatic indexation mechanisms for salaries and pensions.

In such a scenario, all policymakers would realize the limitations of their own tools. Central banks would see that their ability to control inflation is circumscribed by the need to continue monetizing public and private debts. And governments would see that their ability to maintain sanctions on Russia is constrained by the negative impacts on their own economies (in terms of both overall activity and inflation).

There are two possible endgames. Policymakers may abandon one of their objectives, leading to higher inflation, lower growth, higher long-term interest rates, or softer sanctions—accompanied perhaps by lower equity indices. Alternatively, policymakers may settle for only partly achieving each goal, leading to a sub-optimal macro outcome of higher inflation, lower growth, higher long-term rates, and softer sanctions—with lower equity indices and debased fiat currencies then emerging. Either way, households will feel the pinch, which will have political implications ahead. ©2022/Project Syndicate

Nouriel Roubini & Brunello Rosa are, respectively, professor emeritus of economics at New York University’s Stern School of Business, chief economist at Atlas Capital Team; and CEO of Rosa & Roubini Associates, and a visiting professor at Bocconi University.

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Published: 31 Mar 2022, 10:43 PM IST
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