Stems of stagflation – are we reliving the 1970s?

Fuel prices are skyrocketing. War is raging at the gates of Europe. Even ABBA is back on tour – albeit in avatar form.

As labor unrest intensifies amid the rising cost of living, some are wondering aloud: Are we living the 1970s again?

Another throwback to the disco era came last week when the World Bank raised what it believes to be the very real prospect of “stagflation” – a term we hear with greater regularity and that we’ll likely hear even more in the months to come.

The Washington-based institution, along with a host of other outlets, have released updates over the past fortnight.

They are all saying much the same thing – the global economy is on a path of slowing growth amid further significant price increases accompanied by higher interest rates.

“The global outlook faces significant risks, including escalating geopolitical tensions, a prolonged period of stagflation reminiscent of the 1970s, widespread financial stress caused by rising borrowing costs and worsening food insecurity. “, said the World Bank in its report.

“For many countries, recession will be difficult to avoid,” the Bank concluded, adding that it expected “essentially no rebound” next year.

What is stagflation?

Originally coined in the 1960s and attributed to British MP Iain Macleod, “stagflation” is an amalgamation of the words stagnation and inflation.

And that’s essentially what it’s all about – a situation where economies contract but prices continue to rise.

It’s a toxic mix, often referred to as a “double whammy” for consumers who pay higher prices for goods and services in a context where wages are likely to remain static – and it’s for those who have the chance of having a job as an unemployed person inevitably increases.

For decades, economists did not think such a powerful combination of circumstances was even possible. They thought inflation would only be high when the economy was strong and unemployment low – which seems logical.

But the oil crisis of the 1970s changed all that. Economists and central bankers did not know how to handle a period of high inflation and weak economic growth triggered by commodity and supply shocks.

Back to the future

This sounds a lot like the scenario we face now – a parallel the World Bank highlighted in its latest outlook, where it identified three key ingredients for a stagflationary environment.

The first, “ongoing supply-side disruptions fueling inflation,” is essentially what we saw in the aftermath of the pandemic as economies reopened and supply chains adjusted to a rebound. demand.

When this is “preceded by a prolonged period of very accommodative monetary policy in major advanced economies”, the prospect of stagflation intensifies.

Recent UK fuel shortages are reminiscent of the 1970s

Such policies have been put in place by all the major central banks for much of the past decade with interest rates rocking (even negative) and billions of euros, dollars and pounds being spent every month. to buy bonds to maintain sovereign and commercial borrowing. low costs.

The third feature relates to the “weaker growth outlook” in the context of monetary policy tightening, which is essentially the situation in which the world economy – and in particular the euro zone – has found itself in recent times. .

As interest rates are about to be raised in the euro zone (and are already rising in most major economies), this coincides with a period of economic challenge which is intensifying with the war in Ukraine.

Is the stagflation here?

The “flation” part is certainly there, but the “deer” has yet to appear.

At present, most advanced economies are still doing relatively well – albeit in an environment of gathering storm clouds – and, crucially, unemployment is low.

However, there are vulnerabilities, especially in Europe.

The German economy – the largest in the euro zone – escaped recession by posting growth in the first quarter of the year after contracting in the last quarter of last year.

A recession is defined as two or more consecutive quarters of economic contraction.

Figures from the UK Office for National Statistics concluded this week that the UK economy contracted by 0.3% in April, which, together with the 0.1% dip in March, was the first time that the economy had been contracting for two consecutive months since Covid hit.

The Bank of England has warned of the prospect of recession and double-digit inflation – together these are the raw materials for stagflation.

The OECD was relatively optimistic about the outlook for the UK economy this year, where it expects growth of 3.6% before collapsing next year.

Overall, the Paris-based institution is reluctant to draw too many parallels with the oil shock of the 1970s and believes that the risk of stagflation is limited.

“Global growth will be significantly weaker with higher and more persistent inflation,” said OECD Secretary-General Mathias Cormann, adding that the organization did not foresee a recession although many downside risks loom. on the outlook.

The OECD points out that economies are now less energy-intensive, central banks have stronger mandates and frameworks, and consumers still have a glut of pandemic savings that provide something of a buffer for national economies.

That, he believes, should be enough to stave off stagflation – for now.

The interest rate conundrum

It is in this precarious context that the European Central Bank had to take its monetary policy decisions.

Some argue that the ECB was slow to act on rising prices and should have pulled the lever on rate hikes by now.

The Bank of England and the US Federal Reserve have been raising their interest rates for the past few months.

However, the ECB is walking a monetary tightrope, balancing the need to control inflation without hampering economic growth.

He signaled a 0.25% rate hike next month, followed by a potentially larger move in September, if inflation does not ease.

The Nixon era marked the end of America’s long period of post-World War II prosperity.

She has given herself plenty of leeway should circumstances change, but opinions are divided as to whether she is on the right track.

“For the ECB, a quick and rapid rise in interest rates could prevent an inflationary spiral, but at the cost of a strangulation of economic activity,” wrote Patrick Honohan, former governor of the Central Bank of Ireland, in the Irish Times last week.

“It must be recognized that while monetary policy can keep inflation under control, the recessionary costs of acting too quickly can be high,” he added.

Which begs the question: is recession inevitable when inflation is so high and the measures needed to bring it down are so severe?

And should central banks then do an about-face to support economies again?

The ECB is all too aware of the last two occasions when it raised interest rates (in 2008 and 2011) and had to reverse course soon after.

Can we witness stagflation in Ireland?

Given the distorting effect multinationals tend to have on our GDP, it’s unlikely that we’ll technically fall into a recession anytime soon.

In fact, stockbroker Davy recently raised its outlook for GDP growth this year to double-digit percentage growth based on the stronger-than-expected 10.8% rebound in the first quarter of this year.

However, there was a slight decline in domestic demand in the quarter as consumer spending fell slightly, following another slight decline at the end of last year.

“It’s a little confusing,” said Davy’s chief economist, Conall MacCoille.

“The weak spending data is difficult to reconcile with the more dynamic production data,” he added, pointing to credit and debit card spending which showed a sharp recovery in spending in hotels and restaurants. and other tourism-related activities.

So, are we witnessing the beginning of a decline in consumer spending and is this likely to intensify?

“If wages don’t rise as fast as inflation, there will be a period of weakness in consumer spending,” he said.

He warned that now was not the time to try to tackle it with tax cuts or large-scale social assistance.

The government, he said, should target the most vulnerable households instead.

“You can’t chase prices higher here. If we pay more for oil and energy, that’s ultimately bad news one way or the other,” he explained.

The seriousness of this news largely depends on the duration of the war in Ukraine and the increase in energy prices.

A recession in Ireland seems unlikely at this stage, but the situation could change quickly.

Don’t rule out a return to wide backhands just yet!

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