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Are fears of “stagflation” justified?

An acceleration of inflation as the global economy opened up was predictable—but it may not last
September 2, 2021

A key economic question over the next few years is whether the rise in inflation across developed countries represents a temporary blip or the new normal. If temporary, then central bankers can look through it and keep monetary policy easy, buoying equity markets and allowing bond yields to remain low. But if sustained, central banks would have to hike interest rates.

This could not only cause an equity market correction but also generate “stagflation”—a combination of high inflation and low growth—against which central banks have no good tools. The scenario is unlikely even in the US, where fiscal stimulus more plausibly threatens to drive prices higher. But it is dramatic enough that it should be on investors’ radars.

An acceleration of inflation as the global economy opened back up was both predictable and predicted. As lockdowns were eased and demand surged, supply struggled to keep up. But there are reasons to believe that price rises will not be sustained. It is nearly impossible to have a true price spiral without a wage spiral, and despite anecdotes in the US about signing bonuses and new perks for employees, these are temporary boosts; wage hikes have been far less common. According to the small business survey NFIB, far more firms anticipate raising prices than wages over the next three months. The expectations index published by Conference Board, the business researchers, reveals that while the proportion of consumers anticipating incomes to rise over the next six months has risen moderately, it remains well below historical averages.

Consumer- and market-based inflation expectations are elevated in the short term but they remain well-anchored in the medium term. Some of the major drivers of the recent rise in prices—such as industrial metals, lumber and copper—have flattened out. Moreover, many structural downward pressures on wages and prices, such as digitisation, automation and online retail have accelerated during the pandemic.

So far, major central banks have stayed sanguine. At the last meeting of the Federal Reserve’s rate-setting committee in July, the chairman Jerome Powell once again suggested that recent inflation is transitory. In August the Bank of England’s Monetary Policy Committee predicted an acceleration to 4 per cent—well above its 2 per cent target—but suggested inflation would converge with its target next year. This has been validated by recent figures, with consumer price inflation decelerating to 2 per cent year-on-year in July.

If inflation does indeed settle back down, rates can stay low, which should support financial markets. If it is sustained, policy will have to change and there will soon be attempts to engineer a soft landing. This is something that the Fed and other developed central banks have a terrible track record of doing.

With the Delta variant and the risk of new vaccine-resistant strains potentially impairing growth in the second half of 2021 and beyond, there is some risk of stagflation. This is not the base scenario, but it could impact earnings expectations, sparking a correction in equity markets. Moreover, it could affect relative performance. Low inflation and low rates saw “growth stocks” such as technology outperform “value stocks” such as utilities. Sustained inflation and higher rates would likely reverse this trend.