By Dr John Hawkins, PhD, University of Canberra — The Conversation, 29 June 2022
“Stagflation” is an ugly word for an ugly situation — the unpleasant combination of economic stagnation and inflation. The last time the world experienced it was the early 1970s, when oil-exporting countries in the Middle East cut supplies to The United States and other supporters of Israel, with the supply shock of a four-fold increase in the cost of oil driving up many prices and dampening economic activity globally. Stagflation was thought left behind — but now there is a real risk of it coming back, warns the Bank for International Settlements (BIS) in its latest annual economic report. “We may be reaching a tipping point, beyond which an inflationary psychology spreads and becomes entrenched,” says the BIS.
By “inflationary psychology” it means that expectations of higher prices lead consumers to spend now rather than later, on the assumption waiting will cost more. This increases demand, pushing up prices. Thus expectations of inflation become a self-fulfilling prophecy. The BIS report attributes the current inflation surge to a combination of an unexpectedly strong economic rebound from COVID-19 lockdowns, a sustained switch in demand from services to goods, supply bottlenecks, and Russia’s invasion of Ukraine. The war’s effect in driving up the price of oil, gas, food, fertilisers and other commodities has been “inherently stagflationary.” The BIS also flags heightened financial vulnerabilities including stretched asset prices and high debt levels, which could magnify any growth slowdown. The slowdown in China’s labour productivity is removing an important boost to global economic growth and restraint on global inflation.
Central banks face what one governor has called a “narrow path” — raising interest rates enough to bring inflation down, but not enough to cause a recession. A key lesson from the 1970s is that the long-term costs of doing nothing outweigh the short-term pain of bringing inflation under control. This means governments must curb handouts or tax cuts to help people with cost-of-living pressures: “Expansionary fiscal policy will only make things worse. Assistance must be strictly targeted to those who most need it.” This article has been republished under Creative Commons licence.