There is a growing consensus that the US economy’s inflationary pressures and growth challenges are attributable largely to temporary supply bottlenecks that will be alleviated in due course. But there are plenty of reasons to think the optimists will be disappointed.
NEW YORK – I have been warning for several months that the current mix of persistently loose monetary, credit, and fiscal policies will excessively stimulate aggregate demand and lead to inflationary overheating. Compounding the problem, medium-term negative supply shocks will reduce potential growth and increase production costs. Combined, these demand and supply dynamics could lead to 1970s-style stagflation (rising inflation amid a recession) and eventually even to a severe debt crisis.Until recently, I focused more on medium-term risks. But now one can make a case that “mild” stagflation is already underway. Inflation is rising in the United States and many advanced economies, and growth is slowing sharply, despite massive monetary, credit, and fiscal stimulus.
There is now a consensus that the growth slowdown in the US, China, Europe, and other major economies is the result of supply bottlenecks in labor and goods markets. The optimistic spin from Wall Street analysts and policymakers is that this mild stagflation will be temporary, lasting only as long as the supply bottlenecks do.
In fact, there are multiple factors behind this summer’s mini-stagflation. For starters, the Delta variant is temporarily boosting production costs, reducing output growth, and constraining labor supply. Workers, many of whom are still receiving the enhanced unemployment benefits that will expire in September, are reluctant to return to the workplace, especially now that Delta is raging. And those with children may need to stay at home, owing to school closures and the lack of affordable childcare.
On the production side, Delta is disrupting the reopening of many service sectors and throwing a monkey wrench into global supply chains, ports, and logistics systems. Shortages of key inputs such as semiconductors are further hampering production of cars, electronic goods, and other consumer durables, thus boosting inflation.
Still, the optimists insist that this is all temporary. Once Delta fades and benefits expire, workers will return to the labor market, production bottlenecks will be resolved, output growth will accelerate, and core inflation – now running close to 4% in the US – will fall back toward the US Federal Reserve’s 2% target by next year. On the demand side, meanwhile, it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay. Today’s mild stagflation will then give way to a happy goldilocks outcome – stronger growth and lower inflation – by next year.
But what if this optimistic view is incorrect, and the stagflationary pressure persists beyond this year? It is worth noting that various measures of inflation are not just well above target but also increasingly persistent. For example, in the US, core inflation, which strips out volatile food and energy prices, is likely still to be near 4% by year’s end. Macro policies, too, are likely to remain loose, judging by the Biden administration’s stimulus plans and the likelihood that weak eurozone economies will run large fiscal deficits even in 2022. And the European Central Bank and many other advanced-economy central banks remain fully committed to continuing unconventional policies for much longer.
Although the Fed is considering tapering its quantitative easing (QE), it will likely remain dovish and behind the curve overall. Like most central banks, it has been lured into a “debt trap” by the surge in private and public liabilities (as a share of GDP) in recent years. Even if inflation stays higher than targeted, exiting QE too soon could cause bond, credit, and stock markets to crash. That would subject the economy to a hard landing, potentially forcing the Fed to reverse itself and resume QE.
After all, that is what happened between the fourth quarter of 2018 and the first quarter of 2019, following the Fed’s previous attempt to raise rates and roll back QE. Credit and stock markets plummeted and the Fed duly halted its policy tightening. Then, when the US economy suffered a trade war-driven slowdown and a mild repo-market seizure a few months later, the Fed returned fully to cutting rates and pursuing QE (through the backdoor).
This all happened a full year before COVID-19 broadsided the economy and pushed the Fed and other central banks to engage in unprecedented unconventional monetary policies, while governments engineered the largest fiscal deficits since the Great Depression. The real test of the Fed’s mettle will come when markets suffer a shock amid a slowing economy and high inflation. Most likely, the Fed will wimp out and blink.
As I have argued before, negative supply shocks are likely to persist over the medium and long term. At least nine can already be discerned.
For starters, there is the trend toward deglobalization and rising protectionism, the balkanization and reshoring of far-flung supply chains, and the demographic aging of advanced economies and key emerging markets. Tighter immigration restrictions are hampering migration from the poorer Global South to the richer North. The Sino-American cold war is just beginning, threatening to fragment the global economy. And climate change is already disrupting agriculture and causing spikes in food prices.
Moreover, persistent global pandemics will inevitably lead to more national self-reliance and export controls for key goods and materials. Cyber-warfare is increasingly disrupting production, yet remains very costly to control. And the political backlash against income and wealth inequality is driving fiscal and regulatory authorities to implement policies strengthening the power of workers and labor unions, setting the stage for accelerated wage growth.
While these persistent negative supply shocks threaten to reduce potential growth, the continuation of loose monetary and fiscal policies could trigger a de-anchoring of inflation expectations. The resulting wage-price spiral would then usher in a medium-term stagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflationary debt crisis will continue to loom over the medium term.