The world economy is being hammered on all sides. Russia’s invasion of Ukraine, soaring inflation and rising interest rates are weighing on global growth and pushing many countries towards recession.
That’s reviving concerns about “stagflation” – a noxious combination of high inflation, high unemployment and sluggish economic growth, last seen in advanced economies in the 1970s and early 1980s. The World Bank sounded the alarm last week, slashing its 2022 global economic growth forecast by nearly one-third and warning that “the danger of stagflation is considerable today.” Meanwhile, this weekend’s crypto crash and the S&P 500 falling into bear market levels on Monday have furthered global fears.
So what is stagflation? How similar is today to the 1970s? Is Canada entering a period of stagflation? Here’s what you need to know.
What is stagflation?
Stagflation is what the word sounds like: a combination of “stagnation” and “inflation.” It was coined in the mid-1960s but gained currency in the 1970s. For people who lived through that decade, the word conjures up images of lineups at gas stations, spiraling prices, labour strife and widespread job losses.
There’s no precise definition for stagflation. But generally speaking, it is a period of rapid consumer price growth, slowing economic output (sometimes a recession), and high unemployment. From 1976 to 1982 – the height of stagflation – unemployment in Canada averaged around 8 per cent, while the annual rate of inflation also averaged around 8 per cent, going as high as 12.47 per cent in 1981. The Canadian economy fell into recession once in the mid-1970s and twice in the early 1980s. A recession is usually defined as two successive quarters of declining gross domestic product.
High inflation typically occurs during periods of strong economic growth, when the economy is running hot and unemployment is low. Stagflation, by contrast, offers the worst of both worlds: rapid price growth and widespread joblessness. This puts policy makers in a bind, forcing them to make painful tradeoffs between controlling inflation and inflicting substantial economic pain.
What causes it?
Stagflation typically involves two ingredients: commodity price shocks and economic policy errors.
The most famous supply shock happened in 1973, when the Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo against the United States, Canada and other countries that supported Israel during the Yom Kippur War. The price of oil in North America quadrupled, causing a sharp rise in inflation alongside an economic contraction, as business costs rose and consumer demand dropped.
Inflation and unemployment remained high through the rest of the decade and into the early 1980s, exacerbated by another oil price shock after the Iranian Revolution in 1979.
Fiscal and monetary policy mistakes made things worse. Inflation was already picking up in the late 1960s and early 1970s as a result of rising government spending. Central banks, meanwhile, maintained a monetary policy that was too accommodative – keeping interest rates too low and expanding the money supply – in the belief that they could trade slightly higher inflation for lower unemployment. This proved to be a costly miscalculation, as people adjusted their expectations about inflation and both consumer price growth and unemployment remained high.
Why is the World Bank talking about stagflation?
Inflation has become a major issue for the first time in decades. Consumer prices began rising in the spring of 2021, pushed up by pandemic-related supply-chain bottlenecks, a shift in consumer spending toward durable goods, and huge amounts of fiscal and monetary policy stimulus from governments and central banks around the world. Russia’s invasion of Ukraine has made the problem worse.
“Supply disruptions driven by the pandemic and the recent supply shock dealt to global energy and food prices by Russia’s invasion of Ukraine resemble the oil shocks in 1973 and 1979-80,” the World Bank noted last week.
The annual rate of inflation among Organisation for Economic Co-operation and Development (OECD) member countries averaged 9.2 per cent in April. The OECD expects member-country inflation to average around 9 per cent this year.
As in the 1970s, today’s commodity price spike is crimping economic growth, particularly in oil-importing countries. The surge in inflation, meanwhile, is pushing central banks to raise interest rates rapidly to cool down consumer price growth. This is already slowing economic activity, particularly in the housing market.
The World Bank cut its 2022 global growth forecast to 2.9 per last week, down from its January forecast of 4.1 per cent. And it warned that the world economy may be entering a period of persistently higher inflation.
“Forces supporting the global expansion of output in recent decades – which included technological advances, the shift of labour out of agriculture … globalization, and rapid population growth – were strongly disinflationary. As these fade, alongside recent supply shocks, inflationary pressures could build, echoing the experience of the 1970s.”
Is this a rerun of 1970s-style stagflation?
There are similarities between today and the 1970s. In both periods, commodity price shocks came on the heels of expansionary monetary and fiscal policy. Likewise, both periods seem to be marked by a “structural weakening” in the economy, tied to big-picture shifts in demographics, trade and technology, according to the World Bank.
There are, however, notable differences. Advanced economies are less oil-intensive than in the 1970s, which blunts the impact of rising oil prices.
Employment contracts are less likely to be indexed to inflation today, reducing the chance that wage-price spirals will develop. This can happen when businesses and employees lose faith in the central bank’s 2-per-cent inflation target, and respectively set higher prices and demand higher wages in a mutually reinforcing cycle.
Central banks also have a lot more credibility today than in the 1970s, thanks to three decades of low and stable inflation which started in the 1990s. This has helped keep people’s long-term expectations for future inflation relatively well anchored, despite the current runup in consumer prices.
Is Canada entering a period of stagflation?
It depends on who you ask. Bank of Canada deputy governor Toni Gravelle gave a speech last month arguing that Canada is not about to experience a rerun of the 1970s. Unemployment is at a record low, and the country’s economic growth outlook remains relatively strong. Unlike many advanced economies in Europe and elsewhere, Canada tends to benefit from higher global oil prices as a major energy exporter.
“Given where we are now, we don’t see the stagnant part of stagflation – quite the opposite,” Mr. Gravelle said.
Higher interest rates will certainly cool the Canadian economy – something that can already be seen in the slowdown in real estate sales. But Mr. Gravelle argued that this can happen without causing a large spike in unemployment. “Right now, job vacancies are very high … Employers could stop looking for new workers but keep the ones they have – with little impact on the unemployment rate. That is a scenario that delivers a soft landing,” he said.
Former Bank of Canada governor Stephen Poloz had a slightly different take. Speaking on a podcast last month, he said that a period of stagflation is inevitable following the recent commodity price shock. “The rise in commodity prices and food prices across the board are sucking income out of everybody’s pockets. They’ve lost money for all the other sectors of the economy, so there will be a slowdown in the domestic economy as a result of that,” he said.
At the same time, a period of stagflation does not necessarily mean that the Canadian economy will fall into recession, Mr. Poloz said. He said the central bank may be able to engineer a short period of “technical stagflation” where growth slows a moderate amount, not “the kind roaring stagflation like we had in the seventies.”
Does stagflation cause recession?
Stagflation does not necessarily involve a recession – two quarters of negative economic growth. But the way central banks respond to periods of stagflation can make recessions more likely.
The most famous example is the so-called “Volcker Shock,” named after U.S. Federal Reserve chair Paul Volcker, who led the Fed in the late 1970s and 1980s. Starting in the early 1980s, the Fed began raising interest rates sharply to break the inflationary spiral. The Bank of Canada followed suit, pushing its policy interest rate as high as 21 per cent in 1981.
This concerted push by central banks around the world led to a deep global recession. In Canada, the rate of unemployment hit 13.1 per cent in December, 1982. However, inflation did come down sharply and remained relatively low, averaging below 5 per cent for the rest of the decade.
“The experience of the 1970s was that the delay in raising monetary policy rates ultimately made the required increase much greater,” the World Bank said. “After several months of above-target inflation in major advanced economies, a steeper-than-anticipated policy tightening may now again be required to return inflation to target – and this might trigger a hard landing.”
What can be done about stagflation?
A lot is riding on what happens to inflation. If oil prices start to decline and supply-chain bottlenecks clear, inflation could start trending down in the second half of 2022. That would give central banks more breathing room and allow them to raise interest rates at a more gradual pace, reducing the likelihood that they trigger a recession with sharply higher borrowing costs.
If inflation remains high, however, central banks are expected to keep pushing interest rates higher. The Bank of Canada has warned that it may need to raise its benchmark interest rate to 3 per cent or above if inflation does not start coming down. That’s up from 1.5 per cent today.
The big concern for central bankers is that people will lose faith in their ability to control inflation and start expecting permanently higher inflation. “The lesson from history is that if inflation expectations become unmoored, it becomes much more costly to get inflation back to target,” Bank of Canada governor Tiff Macklem said in March.
This is one of the reasons the Bank of Canada is front-end loading its interest rate hikes. It has raised its benchmark interest rate at three consecutive rate decisions. That included half-point rate increases in April and June – the only 50-basis-point rate hikes since 2000. In remarks last week, Mr. Macklem left the door open to a 75-basis-point rate hike at the Bank of Canada’s next rate decision meeting in July.
Interest rates and inflation are closely linked, which is why the Bank of Canada has been pushing up its key rate to try and keep inflation to a target of 2%. But it’s a careful balance between controlling inflation and not tipping the economy into a recession. THE GLOBE AND MAIL
MARK RENDELL, ABIGALE SUBDHAN AND MATHILDE AUGUSTIN
The Globe and Mail, June 14, 2022