Why fears of a return to stagflation amid weak recovery are overblown

Inflation rates are exceptionally low compared with the late 1970s and early 1980s, and there is little evidence of a rapid broadening of price pressures
What really concerns investors is how policymakers, in particular the Fed, plan to support flagging growth while maintaining financial stability

Nicholas Spiro

Published: 1:30am, 17 Sep, 2021

Why you can trust SCMP

What a difference six months make. In March, respondents to Bank of America’s fund manager survey were overwhelmingly bullish. A net 91 per cent of investors expected stronger global growth, the most optimistic outlook since the survey began in 1994.

However, the latest findings, published on Tuesday, paint a starkly different picture. Only a net 13 per cent of respondents expected growth to improve, the lowest figure since the Covid-19 pandemic erupted.

More worryingly, concerns about stagflation – a toxic mixture of falling output and accelerating inflation – have intensified as hopes that the world economy would experience stronger growth and subsiding inflationary pressures have receded.

The rapid spread of the Delta variant has undermined the recovery. Restrictions to contain the highly contagious strain have hit travel and spending. They have also exacerbated supply bottlenecks that are simultaneously dampening manufacturing activity and spurring inflation.

An extreme example of the damage wrought by the virus is Australia. Renewed lockdowns to counter a surge in infections are driving the economy to the brink of a double-dip recession just as headline inflation hits its highest level since 2008. The predicament poses a dilemma for Australia’s central bank, which is slowing the pace of its asset purchases without knowing how quickly the economy will recover.

02:46

Protesters clash with police in Australia over strict lockdown rules amid Covid-19 surge

The unsettling combination of a faltering recovery and stubborn price pressures is present in other major economies to varying degrees.

On the demand side, survey data showed that China’s services sector contracted last month for the first time since February 2020. In the United States, hiring slowed sharply in August, with the weakest creation of new jobs in seven months.

Even in the euro zone, where manufacturing and services sector activity continues to expand briskly, growth is slowing. This is especially so in export-oriented Germany, where supply chain disruptions have hit the country’s car industry particularly hard.

It is these pandemic-induced supply constraints, which are limiting the worldwide provision of key components at a time of pent-up demand, that are fanning fears about inflation. According to the Drewry World Container Index, the cost of shipping a container from Asia to Europe is 10 times higher than at the start of the pandemic, while the cost from Shanghai to Los Angeles has risen more than sixfold.

As commodity prices surge and pressure builds on manufacturers to raise prices to help offset the surge in input costs, some investors worry that supply constraints will persist for longer than central banks anticipate.

If so, this could lead to broader inflationary pressures as businesses and households react to higher costs by pushing up pay and prices even as growth continues to slow, potentially resulting in a wage-price spiral reminiscent of the stagflation of the 1970s.

These fears are overdone for several reasons. First, the word stagflation is being used loosely. Not only are current rates of inflation exceptionally low compared with those in the late 1970s and early 1980s, there is little evidence of the rapid broadening of price pressures – particularly in labour markets – that would indicate inflation is getting out of control.

Second, there is a blinkered focus on annualised inflation rates, which are a poor gauge of how prices are moving, given last year’s virus-induced collapse in demand. Month-on-month readings are more informative and suggest price pressures are starting to ebb.

In China at least, a little inflation may not be a bad thing

The publication of data on Tuesday showed that the core rate of US inflation – which strips out volatile food and energy prices – grew 0.1 per cent in August from the prior month, the smallest increase since February. While this does not settle the debate over whether the spike in inflation will prove transient or longer-lasting, it provides a more accurate assessment of prices.

Third, bond investors are not that concerned about inflation. Market measures of expected future inflation in the US remain subdued, with the so-called five-year break-even rate currently standing at 2.5 per cent, only slightly above the US Federal Reserve’s target. Moreover, in Japan and Germany, where bond yields are stuck in or near negative territory, deflation is a bigger worry.

Still, just because the global economy is not heading for 1970s-style stagflation, it does not mean the stagflation narrative has run out of steam. Markets tend to overreact and are sensitive to shifts in the economy.

The reality is that growth continues to slow while inflationary pressures remain strong. What really concerns investors is how policymakers, in particular the Fed, plan to support flagging growth while maintaining financial stability.

Central banks are trying to pursue both objectives simultaneously, mainly by withdrawing stimulus cautiously. Yet, by treading such a narrow path, there is a significant risk of a policy mistake.

In Bank of America’s latest fund manager survey, the two biggest threats facing markets were inflation and a repeat of the 2013 “taper tantrum”. The former stems from the risk of policy being too loose, the latter from it being too tight. The Fed has its work cut out.

Nicholas Spiro is a partner at Lauressa Advisory