Opinion – Martin Wolf: Fed must act now to ward off stagflation threat

Will there be a recession in the US and other major economies? The question naturally arose among participants at this year’s World Economic Forum meeting in Davos, Switzerland. However, this is the wrong question, at least for the United States. The correct one is whether we are entering a new era of higher inflation and weak growth, similar to the stagflation of the 1970s. If so, what might this mean?

The similarities are evident between the current “surprise” rise in inflation to levels not seen in four decades and that earlier time when inflation also surprised almost everyone except monetarists. That era was also characterized by the war – the Yom Kippur war in 1973 and the Iraqi invasion of Iran in 1980. These wars also caused oil prices to jump, which squeezed real income. The United States and other high-income economies have experienced nearly a decade of high inflation, shaky growth and weak equity markets. This was followed by sharp disinflation under Paul Volcker, chairman of the Federal Reserve (Fed, the US central bank), and the Reagan-Thatcher shift to the free market.

At the moment, few expect something similar. But a year ago few expected the current rise in inflation. Now, as in the 1970s, the rise in inflation is attributed to supply shocks caused by unforeseen events. Then, like today, that was part of the picture. But excess demand turns supply shocks into sustained inflation as people struggle to maintain real incomes and central banks seek to sustain real demand. This leads to stagflation as people lose faith in stable, low inflation and central banks lack the courage to restore it.

Currently, the markets do not expect such an outcome. Yes, there was a decline in the US stock market. However, by historical standards it is still very expensive: the cyclically adjusted price/earnings ratio of Yale’s Robert Shiller is still at levels surpassed only in 1929 and the late 1990s. slight correction of excesses, which the stock market needed. Markets expect short-term interest rates to stay below 3%. Inflation expectations, shown by the difference between yields on conventional and index-linked bonds, have dropped slightly recently, to 2.6%.

Overall, the Fed should be satisfied. Movements in the markets indicate that his vision of the future – a small downturn triggered by a small tightening leading to rapid disinflation towards the target – is widely approved. Just two months ago, the median forecasts of Federal Reserve Board members and regional chairmen for 2023 were for gross domestic product growth at 2.2%, core inflation at 2.6%, unemployment at 3.5% and of federal funds by 2.8%.

This is indeed an immaculate disinflation, but most likely none of this will occur. Supply in the US is mainly limited by over-employment, as I observed just two weeks ago. Meanwhile, nominal demand has been expanding at a torrid pace. The two-year average of nominal demand growth (which includes the year 2020, hit by Covid-19) was over 6%. Until the first quarter of 2022, annual nominal demand grew by more than 12%.

The increase in nominal domestic demand is arithmetically the product of the increase in demand for real goods and services and the increase in their prices. Causally, if nominal demand expands much faster than real production can keep up with it, inflation is inevitable. In the case of an economy as large as the US, the increase in nominal demand will also affect the prices of supplies from abroad. The fact that policymakers in other countries have followed similar policies will reinforce this. Yes, the Covid-induced recession has created a significant pullback, but not to that extent. The negative supply shock of the Ukraine War made it all worse.

However, we cannot expect this rapid growth in nominal demand to slow to around 4%, which is compatible with potential economic growth and inflation at around 2% per year each. Nominal demand growth is vastly higher than interest rates. In fact, not only has it reached rates not seen since the 1970s, but the difference between it and the ten-year interest rate is much greater than it was then.

Why would people who see their nominal incomes grow at this rate be afraid to take out large loans at low interest rates, especially when many have balance sheets strengthened by Covid-era support? Is it not much more likely that credit growth and therefore nominal demand will remain strong? Consider this: even if nominal demand annual growth were to fall to 6%, that would imply 4% inflation, not 2%.

The combination of fiscal and monetary policies implemented in 2020 and 2021 ignited an inflationary fire. The notion that these flames will go out with a modest move in interest rates and no rise in unemployment is far too optimistic. Suppose, then, that this bleak outlook is correct. Then inflation will fall, but maybe only to 4% or more. Higher inflation would become a new normal. The Fed would then need to act again or it would have to abandon its target, destabilizing expectations and losing credibility. This would be a stagflation cycle – the result of the interaction of shocks with mistakes made by fiscal and monetary policymakers.

The political ramifications are unsettling, especially given a vast supply of mad populists. However, the policy conclusions are also clear. If the 1970s have taught us anything, it’s that the time to contain high inflation is at the beginning, when expectations are still on the side of policymakers. The Fed needs to reiterate that it is determined to reduce demand growth at a pace consistent with US potential growth and the inflation target. Also, talking is not enough. He also needs to.

Translated by Luiz Roberto M. Gonçalves