It doesn't take a psychic to recognise the signs. With global growth slumping and inflation stubbornly high, two of stagflation's key conditions look perilously close to being met.
"In fact," says Wolfgang von Hessling, Chief Economist with LGT Bank Switzerland, "we are in a stagflationary environment." Yet today's stagflation has little in common with the oil-price-shock-driven stagflations of the 1970s and '80s, when inflation hit double digits and recession-bound economies took as long as eight quarters to recover. This time around the experience of stagflation is likely to be very different.
Thanks to savvier policymakers, economically attractive supply-side solutions, and perhaps above all to buoyant, post-pandemic labour markets, today's version of the phenomenon will probably be "a mini episode" von Hessling suggests. "If we’re lucky, it will last no longer than a year." Here’s why.
Characterized by high inflation and low growth (usually due to a combination of high unemployment and stagnant demand), stagflation is a contradiction in terms according to von Hessling. Rising unemployment generally accompanies a period of stagflation. The main triggers of inflationary shock, however, are either a collapse in supply or a surge in demand. These disruptions, in turn, lead to weak growth and rising unemployment. Von Hessling believes that stagflation cannot endure indefinitely, especially in today's economic and market conditions.
Consider, for example, the remarkable resilience of the US labour market. A total of 9.61 million job openings were available in the US in August, up from 8.92 million in the previous month, according to the US Bureau of Labor Statistics' JOLTS report. Layoffs stayed low, while hiring increased. And this despite the fastest run of interest rate rises in decades. Clearly, the world's largest economy is still hungry for workers.
Of course, a solid US labour market could also be viewed as potentially inflationary, inducing the Federal Reserve to boost rates further. But as von Hessling notes, "Central banks have learned a lot since the 1970s. They are a bit more prudent."
Like many observers, von Hessling now believes policymakers will leave interest rates as they are until inflation is dead, rather than continually hiking them. The hope is that by keeping rates high for longer, demand will steadily weaken.
It's a tricky strategy, essentially reliant on the robustness of labour markets to balance the danger of throttling demand too much and provoking a recessionary "hard landing". The risks involved are high, especially considering the data.
The IMF observes that the US is the only major economy that's returned to its pre-pandemic economic growth trend. Global growth overall is projected to fall from an estimated 3.5 per cent in 2022 to just 3 per cent in both 2023 and 2024. Germany, for example, Europe's largest economy, is still recovering from the energy price shock of 2022, and has struggled to grow this year as key export markets have failed to provide support.
As we all know, there's no alternative to decarbonisation.
Even in the US, the restrictive monetary policy is having a dampening effect on virtually all the main drivers of growth, from consumption, through investment, to government spending, which increases the likelihood that the current slowdown will be long-lasting.
What's more, much of the relative strength of the US economy is due to US consumers, who have kept spending despite fears that consumption would collapse as soon as pandemic-related pent-up savings ran low. In addition, the US government's recent and massive fiscal support packages have significantly boosted growth.
Inflation is being fuelled on the supply side by the costs of the energy transition and the re-shoring of production as supply chains adjust to post-pandemic geopolitical realities. Meanwhile, rising prices continue to depress consumer confidence, which fell to a four-month low in the US in September this year.
The US Consumer Price Index (CPI) rose 0.4 per cent in September over the previous month, exceeding market expectations. Core CPI, which excludes volatile energy and food prices, was up 4.1 per cent compared to the same period a year earlier - more than double the Fed's inflation target of 2 per cent. Inflation has begun to accelerate again in other countries too, leading to fears that interest rates will remain high for longer.
As von Hessling remarks, "There's a danger that inflationary expectations may become entrenched in consumers' perceptions." He feels that the current environment is not conducive to growth. In Europe, in particular, the slowdown in China is intensifying problems in the manufacturing and export-oriented industries, which are increasing recessionary risks across the continent.
Even so, von Hessling believes that today's experience of stagflation will not be prolonged. "Economic agents will solve supply-side problems through ramping up productive capacities and innovation, because it's profitable for them to do so," he suggests. "The cost of the energy transition is inflationary, but it's a good investment in the long term. Besides, as we all know, there's no alternative to decarbonisation."
Similarly, on the demand side, "What we're seeing is exactly what central banks wanted. Their interest-rate policy is weakening demand and while that also weakens growth and is borderline recessionary, so far the labour market is holding up quite well. We are working through this (post-pandemic) excess demand."
Stagflation is already a reality, but after "perhaps a year" of suppressed growth, von Hessling suggests that as things currently stand, "It's not very likely that there will be a recessionary catastrophe or huge collapse, but rather ongoing, slow-burning damage to growth." Still, consumers will continue to consume, albeit cautiously, but will postpone buying major items until the dust settles.
As von Hessling acknowledges, inflation could rise still further. But interest rates won't fall until inflation finally does. Meanwhile, for the first time in decades, "Cash is not trash any longer." Furthermore, after the recent bond market rout, "Bonds are investible again," especially at the shorter, less volatile, end of the yield curve.
It may already be too late to prepare for stagflation, but for those with the patience to "stay on the side lines and keep their (cash) powder dry," as von Hessling puts it, this too will pass.
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