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Home >Opinion >Views >The global stagflation threat must not be taken lightly

I have been warning for months that the current mix of persistently loose monetary, credit and fiscal policies will excessively stimulate aggregate demand and lead to inflationary overheating. Compounding the problem, medium-term negative supply shocks will reduce potential growth and increase production costs. Combined, these demand and supply dynamics could lead to 1970s-style stagflation (rising inflation amid a recession) and eventually even to a severe debt crisis. Until recently, I focused more on medium-term risks. But now one can make a case that ‘mild’ stagflation is already underway. Inflation is rising in the US and many advanced economies, and growth is slowing sharply despite massive stimulus.

There is now a consensus that the growth slowdown in the US, China, Europe and other major economies is the result of supply bottlenecks in labour and goods markets. The optimistic spin from Wall Street analysts and policymakers is that this will be temporary, lasting only as long as supply bottlenecks do.

In fact, there are multiple factors behind this summer’s mini-stagflation. For starters, the Delta variant is temporarily boosting production costs, reducing output growth, and constraining labour supply. Workers, many of whom are still receiving unemployment benefits, are reluctant to return to the workplace, especially with Delta is raging in the US. And those with children may need to stay at home, owing to school closures and the lack of affordable childcare.

On the production side, Delta is disrupting the reopening of many service sectors and throwing a wrench into global supply chains, ports and logistics systems. Shortages of key inputs such as semiconductors have hit the production of cars, electronic goods, and other durables, thus boosting inflation. Still, optimists insist that this is all temporary. Once Delta fades and benefits expire, workers will return to the labour market, production bottlenecks will be resolved, output growth will accelerate, and core inflation—now running close to 4% in the US—will fall back toward the US Fed’s 2% target by next year.

On the demand side, it is assumed that the US Fed and other central banks will start unwinding their unconventional monetary policies. Combined with some fiscal drag next year, this will supposedly reduce the risks of overheating and keep inflation at bay. Today’s mild stagflation will then give way to a happy goldilocks outcome—stronger growth and lower inflation—by next year.

But what if this optimistic view is incorrect and stagflationary pressure persists beyond this year? Various measures of inflation are not just above target but also increasingly persistent. For example, in the US, core inflation, which strips out volatile food and energy prices, is likely to be near 4% by end 2021. Macro policies are likely to remain loose, judging by the Biden administration’s stimulus plans and the likelihood that weak eurozone economies will run large fiscal deficits even in 2022. And the European Central Bank and many others remain fully committed to unconventional policies for much longer. Though the US Fed is considering tapering its quantitative easing (QE), it will likely remain dovish and behind the curve overall. Like most central banks, it has been lured into a ‘debt trap’ by the surge in private and public liabilities (as a share of GDP) in recent years. Even if inflation stays higher than targeted, exiting QE too soon could cause bond, credit and stock markets to crash. That would be a hard landing, forcing a policy reversal, as happened between the fourth quarter of 2018 and the first quarter of 2019, when the Fed halted its tightening after credit and stock markets plummeted. Then, when the US economy suffered a trade war-driven slowdown and a mild repo-market seizure a few months later, the Fed returned fully to rate cuts and QE. This was a year before covid broad-sided the economy and pushed the Fed and other central banks to loosen policy, while governments engineered the largest fiscal deficits since the Great Depression. The real test of the Fed’s mettle will come when markets suffer a shock amid a slowing economy and high inflation. Most likely, the Fed will blink.

As I have argued before, negative supply shocks are likely to persist over the medium and long term. At least nine can already be discerned.

For starters, there are trends of deglobalization and rising protectionism, the balkanization and reshoring of supply chains, and the demographic ageing of advanced economies and key emerging markets. Tighter immigration curbs are hampering migration from the poorer Global South to the richer North. A Sino-American cold war threatens to fragment the global economy. And climate change is already disrupting agriculture and causing spikes in food prices. Moreover, persistent pandemics will lead to more national self-reliance and export controls. Cyber-warfare is also disrupting production, yet remains very costly to control. And the political backlash against income and wealth inequality is driving fiscal and regulatory authorities to implement policies strengthening the power of workers and labour unions, setting the stage for faster wage growth.

While all this threatens to reduce potential growth, the continuation of loose monetary and fiscal policies could de-anchor inflation expectations. The resulting wage-price spiral would then usher in a stagflationary environment worse than the 1970s, when debt-to-GDP ratios were lower than they are now. That’s why the risk of a stagflationary debt crisis will continue to loom over the medium term. ©2021/Project Syndicate

Nouriel Roubini is CEO of Roubini Macro Associates and co-founder of TheBoomBust.com

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