Because there will be the specter of stagflation

Because there will be the specter of stagflation

The comment: "Covid and the specter of stagflation" by Patrick Zweifel, Chief Economist of Pictet Asset Management .

The large amounts of money that central banks have fed into the global financial system to curb the economic impact of the Covid pandemic have raised the specter of inflation. Could they lead to uncontrolled price growth? Or worse yet, to that debilitating stagflation process that swept over different parts of the world in the 1970s? We believe not.


The experience of the past decade has made it clear that quantitative easing (QE) does not automatically lead to an increase in consumer prices. For many, however, current inflation concerns are based on the fact that the most recent measures taken by central banks are in many cases more incisive than the QE that was launched in the aftermath of the global financial crisis. More and more often, they are buying private assets and are actually monetizing the huge public deficits. The fear is that monetary and fiscal stimuli – half times and three times higher than in response to the global financial crisis respectively – could turn into a fuel for inflation.

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

Phillips curves


The combination of rapid price growth and a high unemployment rate was a unique case that occurred 50 years ago, but which does not seem to come back right now.

In the 1970s, stagflation had been largely triggered by two oil shocks; the first produced by the Yom-Kippur war of 1973 and the second by the Iranian Revolution of 1979. The high level of dependence on oil in developed countries – the economy at the time was much more oriented towards the manufacturing and industrial sector – meant that those spikes in prices were quickly reflected in the economy. Nowadays, their average dependence on oil is only a little over a third of the 1972 level.

The consequences were then amplified by several other factors. Food was the major component of the household consumption basket, and was particularly sensitive to oil prices, not least because of the cost of fertilizers of mineral origin. In the United States, price controls were abandoned in 1973 and while low unemployment rates at the beginning of the decade offered workers leverage to negotiate wage hikes caused by inflation, and restrictive measures that made it expensive to hire workers during the economic crisis.

In the UK, the authorities tried to compensate for the oil shock with an accommodating monetary policy, which simply accelerated inflationary pressures. Switzerland, for its part, did the opposite, which helped moderate inflation in the country. So while prices went up everywhere, the situation was worse in the UK and less difficult in Switzerland. For their part, the United States took a neutral monetary line, which resulted in two inflation peaks, with an average inflation of 7% over the course of the decade and peaks of almost 14%.


As inflation expectations were incorporated, the relationship between prices and unemployment – known as the Phillips curve – was getting worse. A given level of inflation was accompanied by a higher unemployment rate, before severe monetary measures finally eliminated price pressures and brought expectations to more moderate levels.

The question now lies in whether the impact of the Covid pandemic on economies will be similar to that recorded in the 1970s. We believe not. On the one hand, the current supply shock is not like the oil shock of fifty years ago, to which the economy of that time was not prepared. But this does not mean that there are no risks.


There appear to be two types of supply shock. In the first case, workers could ask for wage increases in view of rising inflation, threatening to fuel a negative spiral. The situation could be reinforced by even higher minimum wages, as politicians could give in to populist pressure. In the second case, some goods and services could become more expensive, as manufacturers have to respond to new regulations imposed by fears of public health authorities – such as increases in costs in the catering and transportation industry, to adapt the need for physical distancing. Deglobalization could further damage supply networks and impose higher costs. Import restrictions now cover 7.5% of world trade, compared to less than 1% in 2009.


Meanwhile, an impetus could still fuel an increase in demand. Especially since, unlike a decade ago, the banking system has enjoyed better health, making it more willing and able to transfer liquidity to the economy in the form of credit creation. At the same time, a larger portion of the current drive is directed towards end users, families and businesses.

But the level at which the stimulus is likely to reach an inflationary effect will largely depend on people's expectations of future inflation. Higher expected inflation leads to an increase in spending, which increases the rate of movement of money, which in turn exerts upward pressure on prices and further fuels inflation. But with zero interest rates, which represent what is known as the liquidity trap, it is difficult to start this cycle. This is because there is no cost in retaining money and therefore there is no strong push to start putting it into circulation – so the speed of money circulation remains low.

Finally, all these stimuli could accelerate production ahead of the economy's potential. This could occur if the measures taken to control Covid were to cause a drop in productivity. Or, more likely, if the reactions of the policy were exaggerated, as the recent increase in US household income could suggest – which rose by 13.4% in a month, or double the previous largest increase, which occurred in May 1975 In this case, inflation may recur. But it is not a risk that we see in the short term. And we certainly don't expect a return to the 1970s.

This is a machine translation from Italian language of a post published on Start Magazine at the URL on Sun, 05 Jul 2020 05:30:29 +0000.