SINCE THE FIGHTING BEGAN in Ukraine, bond yields in the US have moved lower and equities have trailed off by about 2% globally.* Meanwhile, the Federal Reserve Bank of Atlanta’s “GDP Now” forecast has plunged to predict zero growth in the first quarter of 2022. Simultaneously, inflation rages and is likely to be pushed higher by surging global energy and commodity prices owing to war, sanctions, and the threat of supply disruptions. It is little surprise that the word “stagflation” is trending as the world grapples with the possibility of both slower economic growth and higher inflation.
SUPPLY IS USUALLY THE CULPRIT, NOT DEMAND
The combination of higher prices and lower output generally arises from an adverse supply shock. That’s what happened in the 1970s when twin oil embargoes in 1973 and again in 1979 stalled growth and pushed up prices. Something like that could happen again if sanctions or acts of war disrupt the flow of Russian or Ukrainian oil, gas, wheat, corn, and other commodities worldwide.
Higher prices would reinforce a demand-driven surge in prices and wages already underway before the invasion. Accelerating inflation followed an unprecedented peacetime fiscal expansion in 2020–2021 that coincided with sluggish production, distribution, and labor supply responses owing to pandemic disruptions. Inflation has also been exacerbated by a shift in consumer spending from services to goods that caught producers off guard.
US INFLATION IS RISING, BUT UNLIKELY TO LEAD TO STAGFLATION
There are two reasons why stagflation in the United States is unlikely. The first is that adverse supply shocks are only a part of why inflation is now high. Excess demand is a bigger part of the story, and demand is already slowing. As it does, price and wage pressures are apt to abate.
The second reason is that an adverse supply shock cannot create sustainably higher inflation by itself. Either it must unleash a wage-price spiral, or it must prompt central banks to ease and over-stimulate demand.
Readers may be puzzled — aren’t prices and wages going up already? Yes, they are. But the key is understanding the difference between a one-time “shock” of demand exceeding supply — which is what the United States and much of the world economy has recently experienced — and an ongoing spiral of prices, which can only result from persistent ongoing increases in demand greater than supply. The latter leads to ongoing inflation. The former to a temporary period of price increases that, on its own, will plateau.
So why is demand unlikely to outstrip supply? One key reason is a collapse in purchasing power. Wage growth adjusted for inflation is falling rapidly, the worst period of real wage decline in a quarter century. The US February employment report provided further evidence — average hourly earnings are not keeping pace with rising prices.
Some observers might counter that workers will step up their demands for higher wages. That might happen, but a return to 1970s-style wage-price spirals seems unlikely. Unionization rates have plunged in the past half century, eroding collective bargaining power of workers. Automatic cost-of-living adjustments are a distant memory. Also, surveys and market indicators show that long-term inflation expectations are not consistent with a broad-based anticipation of durable higher inflation. If households and investors believed that a wage-price spiral was likely, long-term inflation expectations would surely be rising.
Another reason why inflation expectations have not moved much is that the 2021 spending boom has peaked. Household savings have fallen back to pre-pandemic levels, suggesting that “pent up” demand is receding. Meanwhile, last year’s COVID-19-relief checks, child tax credits, and healthcare spending surges are over. Last year’s government spending is not being repeated this year. Fiscal stimulus is rapidly becoming fiscal drag. In the United States, fiscal policy could lop off at least percentage point from gross domestic product growth this year.
In short, neither precondition for the inflation side of stagflation is probable. Demand appears unlikely to outpace supply on a recurring basis. And a wage-price spiral appears unlikely.
EUROPE FACES MORE UNCERTAINTY
In Europe, the situation is different. Unlike the United States, Europe is a major energy importer, both for crude oil and natural gas. Gas storage was already at low levels going into this crisis, creating conditions where higher prices will unambiguously dent European household purchasing power and hence overall demand. Europe’s reliance on Russia and Ukraine for key agricultural commodities and metals could also impact input costs for businesses across multiple industries, further impacting inflationary pressures. For all those reasons, the downside risks to growth in Europe are significantly higher than those in the United States. And, like the United States, measured inflation is being boosted by one-time supply shocks, above all coming from commodity prices.
SLOWING GROWTH IS THE RISK CHINA IS FOCUSED ON
China has experienced slowing growth in recent years, accelerated by zero-COVID policies and rising input costs, especially commodity costs, that have not been passed to the consumer over the past two years. Domestically, China remains hamstrung by property market excesses, many of which resulted from past lax borrowing standards and poor investment decisions. At the same time, the Chinese leadership has expressed its displeasure with growth that risks falling below 5%. If US growth cools this year and Europe’s recovery stalls, China’s export engine will not likely be sufficient to meet Beijing’s overall growth objectives.
FOCUS ON CENTRAL BANK RESPONSES
What does all this mean for monetary policy and interest rates?
Despite slowing growth and rising uncertainty, the Federal Reserve (Fed) remains committed to tightening US monetary policy. To be sure, Russia’s invasion of Ukraine has changed the calculus about how fast the Fed will move. Fed Chairman Jerome Powell openly stated his preference for a quarter point hike at this month’s Federal Open Market Committee meeting, quashing any expectations for a larger move. Russia was the reason.
Yet the Fed remains confident that fallout from the war will be modest. Partly that is because the US is energy self-sufficient. While higher oil prices will probably weaken US growth via falling real wages in 2022, the impact will likely be smaller than during the 1970s oil embargoes when the United States was a major energy importer and energy was a larger part of the economy.
The European Central Bank (ECB) faces a bigger challenge about what to do. Its mandate is singular — keep inflation low. But it cannot realistically ignore that war and surging commodity prices imperil any economic recovery. European countries may boost defense spending, but that impact won’t be felt for quarters or perhaps years. Accordingly, the ECB will be hesitant to follow the Fed’s rate hiking cycle, even if reported inflation remains above the ECB’s target.
But perhaps the most interesting central bank to watch this year will be the People’s Bank of China (PBOC). The reverberations of Russia’s invasion, coupled with the end of Western fiscal stimulus is pushing the PBOC to buck a global tightening trend and ease monetary policy in 2022. Global growth, which in the past two years was held up by western fiscal stimulus, may be shifting again eastward, as China moves to prop up its economy.
The bottom line is that investors should avoid being swept up in discussions about stagflation. It is a term more prevalent in the media than economics, and for good reason. Instead, astute investors will focus on how central banks respond to the shifting fortunes of the world economy and the jolt delivered by war. Their actions will drive developments in global bond markets and, hence, across all portfolios.
*Source: MSCI. From Feb. 24, 2022 through March 4, 2022.
Stephen Dover is the chief market strategist and head of Franklin Templeton Investment Institute.
