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assessing risk of stagflation

June 2020

Covid and the spectre of stagflation

Will huge amounts of stimulus trigger the sort of stagflation that ravaged the world in the 1970s? We don't think so.

The vast volumes of money central banks have pumped into the global financial system to contain the economic impact of the Covid pandemic have raised the spectre of inflation. Could these ignite uncontrolled price pressures? Or, worse still,  the sort of debilitating stagflation that swept significant parts of the world during the 1970s? We don't think they will.

Experience of the past decade has made it clear that quantitative easing (QE) isn’t a straight path to rising consumer prices. For many, however, current inflation fears hinge on the fact that central bankers’ latest measures are in many cases far in excess of the QE that was launched in the wake of the global financial crisis. Increasingly, they are buying private assets and de facto monetising huge government deficits. The fear is that monetary and fiscal stimulus – respectively half and three times as big again as in response to the global financial crisis – could yet prove to be inflationary fuel.

The good news is that Covid is unlikely to lead to the stagflation that gripped the world during the energy crisis of the 1970s.

Phillips curves
The estimated relationship curves between US inflation and unemployment rates for various periods. Dots represent average unemployment and inflation rates for given years, according to legend.

Source: Pictet Asset Management,Refinitiv. Data as at 20.05.2020

The combination of fast rising prices and high unemployment  was unique to the circumstances of 50 years ago, which don’t seem to be mirrored in current events.

The 1970s stagflation was largely triggered by two oil shocks – the first precipitated by the 1973 Yom-Kippur War, the second by the 1979 Iran Revolution. Developed economies’ high degree of dependence on oil – output then was much more heavily geared to manufacturing and industrial production – meant that these price spikes quickly fed through the economy. These days their average dependence on oil is only a little more than a third of what it was in 1972.

The fallout back then was amplified by several other factors. Food made up a much bigger part of people’s consumption basket, and was particularly sensitive to oil prices, not least through the cost of oil-based fertilisers. In the US, price controls were abandoned by 1973, while the low unemployment rates at the start of the decade gave workers the leverage to negotiate inflation-busting wage rises and restrictive measures that made it expensive to hire workers during the economic crisis later on. 

In the UK, authorities tried to offset the oil shock with accommodative monetary policy, which merely accelerated inflationary pressures. The Swiss, on the other hand, did the opposite, which helped to moderate inflation there. So while prices jumped everywhere, it was worst in the UK and least bad in Switzerland. For its part, the US took a neutral monetary line, resulting in two inflationary spikes, averaging at more than 7 per cent over the decade and with a peak at some 14 per cent.

Shifting the Phillips curve

As inflation expectations became embedded, the trade-off between prices and unemployment – known as the Phillips curve – worsened. A given level of inflation became associated with ever higher unemployment before severe monetary measures finally suppressed price pressures and returned expectations to more moderate levels.

The question now is whether the Covid pandemic’s impact on economies is similar to that seen during the 1970s. We don't think so. For one thing, the current supply shock isn't like the oil shock of fifty years ago for which the economy then was ill prepared. But that doesn't mean there are no risks.

Two sorts of supply shock seem possible. First, workers could demand higher wage settlements in anticipation of rising inflation, which would threaten to feed a negative spiral. This could be reinforced by ever higher minimum wages as politicians bow to populist pressure. Second, some goods and services could become more expensive as producers respond to new regulations imposed by public health concerns – such as rising restaurant bills and transportation costs to reflect social distancing needs. Deglobalisation could further damage supply networks and impose rising costs. Import restrictions now cover 7.5 per cent of global trade from less than 1 per cent in 2009. 

The good news is that Covid is unlikely to lead to the stagflation that gripped the world in the 1970s.

Meanwhile, stimulus could yet stoke a surge in demand. Especially since, unlike a decade ago, banks now are in much ruder health, making them much more willing and able to pass the liquidity on to the wider economy in the form of credit creation. At the same time, a bigger proportion of today’s stimulus is directed to the end-users, households and businesses.

But the degree to which the stimulus is likely to be inflationary depends in large part on people’s expectations of future inflation. Higher expected inflation prompts rising spending which increases how fast money circulates, which pushes up prices and boosts inflation further. But with interest rates at zero, reflecting what’s known as a liquidity trap, it becomes hard for this cycle to kick in. That’s because there is no cost to holding money and thus no strong push to start it circulating – so the velocity of money stays low.

Ultimately, all this stimulus could boost output ahead of the economy’s potential. That could happen if measures to control Covid cause productivity to fall. Or, more likely, if policy responses were overdone as may be suggested by the recent surge in US household income – at 13.4 per cent on the month, that’s twice the size of the previous largest increase which came in May 1975. In that case, inflation could well rear its head again. But that’s not a risk we see in the near term. And certainly not a return to the 1970s.