With “Team Persistent” having clearly prevailed over “Team Transitory” in the debate over the nature of today’s surging inflation, the question now is whether prices can be tamed without also causing a recession. The historical evidence suggests not, leaving central banks to choose between bad and worse options.
NEW YORK – In 2021, the big debate about the outlook for the global economy focused on whether the rising inflation in the United States and other advanced economies was transitory or persistent. Key central banks and most Wall Street researchers were on “Team Transitory.” They attributed the problem to base effects and temporary supply bottlenecks, implying that the high inflation rate would rapidly fall back to central banks’ 2% target range.
Meanwhile, “Team Persistent” – led by Lawrence H. Summers of Harvard University, Mohamed A. El-Erian of Queens’ College at the University of Cambridge, and other economists – argued that inflation would remain high, because the economy was overheating from excessive aggregate demand. That demand was driven by three forces: persistently loose monetary policies, excessively stimulative fiscal policies, and a rapid accumulation of household savings during the pandemic, which led to pent-up demand once economies reopened.
I, too, was on Team Persistent. But I argued that, in addition to excessive aggregate demand, several negative aggregate supply shocks were contributing to rising inflation – indeed, to stagflation (reduced growth alongside higher inflation). The initial response to COVID-19 had led to lockdowns, which caused major disruptions to global supply chains and reduced the supply of workers (creating a very tight labor market in the US). Then came two additional supply shocks this year: Russia’s brutal invasion of Ukraine, which has driven up commodity prices (energy, industrial metals, food, fertilizers), and China’s “zero-COVID” response to the Omicron variant, which has led to another round of supply-chain bottlenecks.
We now know that Team Persistent won the 2021 inflation debate. With inflation surging close to double digits, the US Federal Reserve and other central banks have conceded that the problem is not transitory, and that it must be urgently addressed by tightening monetary policy.
That has spurred another big debate: whether economic policymakers can engineer a “soft landing” for the global economy. The Fed and other central banks contend that they will be able to raise their policy rates by just enough to pull the inflation rate down to their 2% target without causing a recession. But I and many other economists doubt that this Goldilocks scenario – an economy that is neither too hot nor too cold – can be achieved. The degree of monetary-policy tightening that is needed will inevitably cause a hard landing, in the form of a recession and higher unemployment.
Because stagflationary shocks both reduce growth and increase inflation, they confront central banks with a dilemma. If their highest priority is to fight inflation and prevent a dangerous de-anchoring of inflation expectations (a wage-price spiral), they must phase out their unconventional expansionary policies and raise policy rates at a pace that would likely cause a hard landing. But if their top priority is to sustain growth and employment, they would need to normalize policy more slowly and risk unhinging inflation expectations, setting the stage for persistent above-target inflation.
A soft-landing scenario therefore looks like wishful thinking. By now, the increase in inflation is persistent enough that only a serious policy tightening can bring it back within the target range. Taking previous high-inflation episodes as the baseline, I put the probability of a hard landing within two years at more than 60%.
But there is a third possible scenario. Monetary policymakers are talking tough nowadays about fighting inflation to head off the risk of it spinning out of control. But that doesn’t mean they won’t eventually wimp out and allow the inflation rate to rise above target. Since hitting the target most likely requires a hard landing, they could end up raising rates and then getting cold feet once that scenario becomes more likely. Moreover, because there is so much private and public debt in the system (348% of GDP globally), interest-rate hikes could trigger a further sharp downturn in bond, stock, and credit markets, giving central banks yet another reason to backpedal.
Simply put, the effort to fight inflation could easily crash the economy, the markets, or both. Already, central banks’ modest amount of tightening has shaken financial markets, with key equity indices near bear territory (a 20% decline from recent peaks), bond yields rising higher, and credit spreads widening. Yet if central banks wimp out now, the outcome will resemble the stagflationary 1970s, when a recession was accompanied by high inflation and de-anchored inflation expectations.
Which scenario is most likely? It all depends on a combination of uncertain factors, including the persistence of the wage-price spiral; the level to which policy rates must rise to rein in inflation (by creating slack in goods and labor markets); and central banks’ willingness to inflict short-term pain to hit their inflation targets. Moreover, it remains to be seen what course the war in Ukraine will take, and what effect that will have on commodity prices. And the same goes for China’s zero-COVID policy, with its effect on supply chains, and for the current correction in financial markets.
The historical evidence shows that a soft landing is highly improbable. That leaves either a hard landing and a return to lower inflation, or a stagflationary scenario. Either way, a recession in the next two years is likely.