WBAD do the stagflationary forces acting on the world economy last? Throughout 2021, central banks and most economists have said the factors causing inflation to rise and growth to slow down will be temporary. Supply chain bottlenecks would ease, energy prices would return to the land, and workers of the rich world would remain outside the workforce – for reasons no one fully understands – would return to work. And yet, as 2021 draws to a close in financial markets, the public and even central bankers themselves are starting to lose confidence.
The dilemma facing policy makers is acute. The classic response to inflation caused by supply disruptions is to ignore it and let it go away on its own. Why hurt economies with higher interest rates, which won’t unlock ports, spark new natural gas supplies, or end the pandemic? In 2011, inflation in Britain hit 5.2% due to rising commodity prices, but the Bank of England kept interest rates low. In the eurozone, the European Central Bank raised rates, which helped plunge its economy back into recession, and quickly found itself with inflation well below its target. As then, inflation in 2022 driven by high energy prices is expected to subside. (Inflation is the rate of price change, which means that even if prices don’t return to previous levels, just don’t increase that quickly.)
Yet the comparison with the early 2010s is inaccurate. The woes of global trade in 2021 were not just caused by disrupted supplies, such as the covid-19 outbreaks shutting down factories in Vietnam. There was also excess demand. Massive fiscal and monetary stimulus, combined with social distancing, have led consumers to gorge on goods, from game consoles to tennis shoes. In the summer of 2021, Americans’ spending on physical matters was 7% higher than the pre-pandemic trend. In other countries, too, there is only a shortage of goods compared to an unusually high demand. For the global economy to return to something like normal, consumers must spend more of their plentiful money on services, such as dining out and travel.
The rich world has not seen a wage-price spiral since the 1970s
Unfortunately, economies are plagued by shortages of the workers necessary for the prosperity of service industries. Wages in leisure and hospitality are skyrocketing. Many economists hoped that workers would return to the end of emergency support for labor markets, such as leave schemes and emergency unemployment insurance. So far, there are surprisingly few signs that this is happening. For inflation to be temporary, wage growth as well as price growth must probably fall. The alternatives are an unlikely increase in productivity or lower profit margins, which for businesses such as restaurants are already slim.
Some policymakers are starting to fear the opposite: wage growth continues to rise as workers expect inflation to rise. The rich world has not seen a wage-price spiral since the 1970s, and the Doves argue that in economies without widespread unionization, workers are unlikely to negotiate higher wages. But if rising inflation expectations turn out to be self-fulfilling, the job of central banks would suddenly become much more difficult. They would not be able to keep inflation at the target level without sacrificing jobs. Emerging markets are used to this painful trade-off between growth and inflation, but it hasn’t taken a bite out of the rich world in decades. In large, rich countries, the Bank of England is closest to tightening — only to preserve the credibility of its inflation target, rather than because it is justified by underlying economic conditions.
Central bankers in trouble
It’s easy to imagine that policymakers raise interest rates and end up regretting it. Although inflation remains high in the first months of 2022, central bankers generally believe it takes a year and a half for higher interest rates to have their full effect on the economy. The forces that previously kept global rates and inflation low – demographic change, inequality and a soaring global demand for safe assets – may have reasserted themselves by then. Looming budget cuts in many countries will help the economies cool: Britain has announced big tax hikes and President Joe Biden is struggling to push big spending bills through Congress. And the slowdown in growth in China, which is grappling with a slowdown in the real estate market, could spill over globally.
Above all, the pandemic is not over. The spread of the virus could further disrupt economies if immunity wanes and new variants can escape vaccines. But with supply chains at their limits, the world cannot repeat the trick of sustaining economic growth by using stimulus measures that shift consumer spending towards goods. Instead, central banks should stifle spending with higher rates to avoid excessive inflation as the economy’s supply adapts to spending and labor patterns that are very different from those prevailing in the economy. 2010s. If normalcy does not return in 2022, the alternative is a painful economic adjustment.
Henry Curr: Economics Editor, The Economist■
This article appeared in the Leaders section of The World Ahead 2022 print edition under the title “Bounce or rebalance”