Only last year, many economists were expecting 2022 to be a period of strong economic rebound. Businesses would return to full operation post-Covid. Consumers would be free to splash their accumulated savings on all the holidays and activities they had not been able to do during the pandemic. It would be a new “roaring twenties,” some said, in reference to the decade of consumerism that followed the 1918-21 influenza.
Fast forward a few months and the more commonly cited parallel is the 1970s, when the Arab oil embargo helped create a prolonged period of economic hardship. Inflation surged to double-digit rates even as economies around the world stagnated — a painful mix of high prices and low growth known as “stagflation”.
Now, stagflation is again on the cards. After the double shock of Covid-19 and the Russian invasion of Ukraine, inflation rates have exceeded expectations, surging to the highest levels in decades in many countries, while economic growth forecasts are rapidly deteriorating.
The prospect of stagflation’s return strikes fear into policymakers because there are few monetary tools to address it. Raising interest rates may help reduce inflation, but increased borrowing costs would further depress growth. Keeping monetary policies loose, meanwhile, risks pushing prices higher.
Most analysts and economists, including the IMF, do not expect a rerun of the bad old days of the 1970s — a decade of economic blight that caused pain to households and businesses alike. Inflation is not yet as high as it was back then; more central banks are independent; and fiscal support is shielding the most vulnerable.
But just as the oil crisis reverberated throughout the global economy in the 1970s, so has the double blow of pandemic and war put unprecedented pressure on the supply of goods and services around the world today.
Even before war broke out in Ukraine, prices had risen to multi-decade highs in many countries, including the US, the UK and the eurozone, as the pandemic disrupted supply chains, boosted demand for goods and resulted in accommodative monetary policies and expansive fiscal stimuli.
The war only exacerbated these problems. Russia and Ukraine produce large amounts of the global supply of gas, oil, wheat, fertilisers and other materials, pushing energy and food prices higher, especially in Europe.
This is the “largest commodity shock we’ve experienced since the 1970s,” says Indermit Gill, the World Bank’s vice-president for equitable growth, finance and institutions. In the event of a prolonged war, or additional sanctions on Russia, “prices could be even higher than currently projected,” he adds.
Forecasts are looking chilly. The consensus is now for global economic growth to average only 3.3 per cent this year, down from 4.1 that was expected in January, before the war. Global inflation is forecast at 6.2 per cent, 2.25 percentage points higher than January’s forecast. Similarly, the IMF downgraded their forecast for 143 economies this year — accounting for 86 per cent of global gross domestic product.
Stagflation matters because few economists agree on how to stop it once it has started. It also causes great, potentially long-term pain to businesses and middle class and lower-wage households. “In economic terms, growth is down and inflation is up,” says Kristalina Georgieva, IMF managing director. “In human terms, people’s incomes are down and hardship is up.”
The worldwide ebb
The stagflationary shock of 2022 is truly global, with diverging growth and inflation expectations across most countries with many different factors exacerbating the trend in a synchronised way.
In country after country, similar trends can be seen playing out — a surprise surge in prices and decline in activity over the past few months — as expectations for the year deteriorate.
Across Asia, strong growth forecasts have been revised down due to headwinds from the war in Ukraine, and renewed supply disruptions and weaker demand resulting from China’s new lockdowns and Xi Jinping’s zero-Covid policy.
Inflation is more muted in Asia than in other countries, but it is edging up following the global surge in food and energy prices. In South Korea, for example, consumer prices hit a 10-year high in March.
In some Latin American countries, particularly Brazil, the aggressive monetary policy tightening adopted to tame soaring inflation has resulted in a fast-deteriorating economic outlook. The UN’s Economic Commission for Latin America and the Caribbean revised growth prospects for the region downward on April 27, warning of a “complex juncture” of challenges relating to the war in Ukraine.
Despite being confined to Europe, the effects of the war “are being felt worldwide as rising energy and food prices are impacting the most vulnerable, particularly in Africa and the Middle East”, said David Malpass, president of the World Bank.
But unsurprisingly the economic shock of the war is being most keenly felt in Europe, especially in those countries heavily reliant on Russian oil and gas.
The European region as a whole is highly vulnerable to disruptions to its energy supply, with 40 per cent of the EU’s gas coming from Russia. Consumer energy prices already surged in March, with business and consumer sentiment taking a plunge. Many experts are warning that an EU ban on Russian gas would trigger one of the deepest recessions of recent decades in Germany and the eurozone.
Russian retaliations on energy exports are also a threat to the region’s economic outlook, partly realised last week when state energy giant Gazprom said it would cut off supplies to Poland and Bulgaria.
“If Moscow abruptly halts the flow of its natural gas to Germany and other EU economies, Europe will find itself grappling with a new economic crisis, that like the euro crisis of 2011-12 or the Covid crisis of 2020 could again pose an existential threat to the single currency’s survival,” says Tom Holland at Gavekal Research.
Even without gas stoppages, growth in the eurozone slowed to just 0.2 per cent in the first quarter, while inflation rose to a record high of 7.5 per cent. “This will be a year of stagflation” in the eurozone, says Andrew Kenningham, chief Europe economist at Capital Economics. “Higher energy prices will keep inflation elevated, squeeze household incomes and dent business confidence.”
Germany is among the hardest hit, with its energy-intensive, large manufacturing sector and export-oriented economy. Over the past six months, economists have halved their 2022 economic growth forecast for Germany, while inflation expectations are three times higher.
Outside the EU, the UK economy nevertheless suffers from similar energy price pressures and flattening growth this year, following what is forecast to be the largest drop in real income since records began in the 1950s.
However, in the UK, high prices of imported goods are coupled with a tight labour market that raises the prospect of a more persistent high inflation. The UK unemployment rate is at the lowest it has been since the early 1970s and job vacancies are the highest on record, risking a “wage-price spiral” when higher pay demands push prices ever higher.
“This combination of supply shocks and a tight labour market tends to give us more of a problem [of persistent inflation],” Andrew Bailey, the governor of the Bank of England, told the Financial Times in an interview this month.
But it is the US that faces “by far greatest risk of dramatic inflation and wage-price spirals,” says Anatole Kaletsky, economist at the investment research company Gavekal. Inflation hit 8.5 per cent in March and investors expect it to rise even higher. The economy contracted unexpectedly in the first quarter, defying predictions.
The US labour market, meanwhile, is the most overheated in postwar history with more than 5mn fewer jobs — actual employment and unfilled job openings — than workers, according to Daan Struyven, economist at Goldman Sachs.
The overheated nature of the labour market, said former Treasury secretary Larry Summers in a recent analysis, suggests “a very low likelihood that the Federal Reserve can reduce inflation without causing a significant slowdown in economic activity”.
Struyven notes that signs of tight labour markets are visible in most English-speaking G10 countries, including the UK, Canada and Australia.
The health of the labour market affects what policymakers are expected to do about high inflation, which in turn impacts borrowing costs and living standards.
Stronger domestic price pressures coming from wage growth and higher core inflation, which strips out energy and food, have prompted expectations for multiple rates hikes in the UK and the US.
Futures markets now reflect an 80 per cent chance the US fed funds rate will be at 1.5 per cent in June, implying a half-point increase at each of the next two meetings, according to the CME’s FedWatch tool. That would follow the 25 basis points hike in March, the first since 2018.
The Bank of England is also expected to raise rates for the fourth consecutive time at the next meeting, on May 5, to 1 per cent as the country faces the fastest pace of inflation in 30 years. Markets expect further hikes to 2 per cent by the end of the year.
By contrast, the European Central Bank has not raised rates in over a decade from its current minus 0.5 per cent despite having similar headline inflation rates to the UK and the US, which is also the highest in the history of the currency union.
Christine Lagarde, president of the ECB, said recently that the US and Europe were “facing a different beast”. In America, it’s the tight labour market pushing prices up. In Europe, it’s surging energy costs.
“If I raise interest rates today, it is not going to bring the price of energy down,” Lagarde said. But even in the eurozone, the exceptional surge in inflation prompted the market to price in 80 basis points of rate hikes from the ECB by the end of the year.
The global outlook “for monetary tightening has increased notably, as has the potential for stagflation,” says Fitch, the credit rating company.
Turning back the clock
The question now is how long this stagflationary shock will last — and whether a prolonged, 1970s-style slump is still a possibility.
Back then, inflation rose to double-digit rates for almost a decade, following a large spike in oil prices after the Arab oil-exporting countries stopped exporting to many western countries as punishment for providing aid to Israel during the Yom Kippur war.
Persistent high inflation pushed unemployment rates to high levels in many advanced economies, leaving behind the boom years after the second world war.
While today’s sharp increases in commodity prices echo those in the 1970s, there are many differences from that period. Many economists expect inflation to slow next year, pointing out that the world’s reliance on fossil fuels is lower now.
Households can now cushion the blow of the higher energy costs with the savings accumulated during the pandemic. Many economies, mostly the rich ones, have introduced measures to shield the most vulnerable groups from the hit of rising prices, including subsidising fuel and energy costs.
However, other trends are a source of concern for both growth and inflation, adding to a highly uncertain outlook.
While oil price growth might be weaker than back then, the increase in gas price has been rapid and was enough to push March’s annual growth of German producer prices to the highest pace since records began in 1949 and double the pace of in the 1970s.
Although wages are no longer indexed to inflation as they were in the 1970s, the historically tight labour markets in the US and Europe increase the risk of inflation becoming more entrenched in the economy. Whatever happens to commodity and goods prices in the near term, “the key point remains that high inflation is only likely to be seen on the sustained scale seen in the 1970s if wage-price spirals develop,” says Vicky Redwood, economist at Capital Economics.
Forecasts could also be overly optimistic. Economic data has often disappointed expectations and “growth [this year] could slow further than forecast, and inflation could turn out higher than expected”, says the IMF.
More central banks are independent and monetary policy credibility has generally strengthened over the decades, but hiking rates hurts businesses and households at a time when they already see their real income eroded by rising prices.
With private and public debt levels at historic highs as a share of GDP, “central bankers can take policy normalisation only so far before risking a financial crash in debt and equity markets”, warns Nouriel Roubini, professor of economics and international business at New York University Stern School of Business.
It is also possible, adds Silvia Dall’Angelo, economist at the investment management company Federated Hermes, that the pandemic and the war in Ukraine “have catalysed some structural changes reversing some of the forces that caused disinflation in previous decades”, including globalisation.
The result is that global inflation forecasts are being revised upwards for next year, while growth expectations are deteriorating. If these come to pass, it will mean an erosion of business profits and households’ purchasing power for longer, with high inflation affecting lower-income households the hardest.
“It may not be exactly like the 1970s,” says Luigi Speranza, chief global economist at BNP Paribas Markets 360, “but it will still feel like stagflation.”