Will there be a recession in the United States and other major economies? These questions naturally arose among participants at this year’s meeting of the World Economic Forum in Davos. This is, however, the wrong question, at least for the United States. The good one is whether we are entering a new era of higher inflation and weak growth, similar to the stagflation of the 1970s. If so, what could that mean?
The similarities are evident between the current “surprise” rise in inflation to levels not seen in four decades and that earlier era, when inflation was also a surprise to almost everyone except the monetarists. This era was also characterized by war – the Yom Kippur War in 1973 and Iraq’s invasion of Iran in 1980. These wars also triggered spikes in oil prices, which reduced income real. The United States and other high-income economies have experienced nearly a decade of high inflation, unstable growth and weak stock markets. This was followed by sharp disinflation under Federal Reserve Chairman Paul Volcker and the Reagan-Thatcher turn to free markets.
For the moment, few expect something similar. But a year ago, few expected the current surge in inflation. Today, as in the 1970s, rising inflation is blamed on supply shocks caused by unexpected events. Then, as now, it was part of the picture. But excess demand causes supply shocks to turn into sustained inflation, as people struggle to maintain real incomes and central banks seek to prop up real demand. This then leads to stagflation, as people lose faith in stable, low inflation and central banks lack the courage to restore it.
At present, the markets do not expect such an outcome. Yes, there has been a decline in the US stock market. Yet by historical standards, it is still very expensive: Yale’s Robert Shiller cyclically-adjusted price-to-earnings ratio is still at levels surpassed only in 1929 and the late 1990s. a slight correction of excesses, which the stock market needed. Markets expect short-term interest rates to stay below 3%. Inflation expectations, illustrated by the spread between the yields of conventional and indexed Treasury bills, have even fallen a little recently, to 2.6%.
All in all, the Fed should be pleased. The movements in the markets indicate that his view of the future – a slight slowdown triggered by a slight tightening leading to rapid disinflation towards the target – is widely accepted. Just two months ago, median forecasts by Federal Reserve board members and regional presidents for 2023 called for gross domestic product growth at 2.2%, core inflation falling to 2, 6%, unemployment at 3.5% and a federal funds rate at 2.8. percent.
This is indeed perfect disinflation, but nothing like that is likely to happen. The American supply is mainly constrained by the overcrowding, as I noticed just two weeks ago. Meanwhile, nominal demand has grown at a breakneck pace. The two-year average growth in nominal demand (which includes the Covid-19-hit year 2020) was above 6%. In the year leading up to the first quarter of 2022, nominal demand actually increased by more than 12%.
Growth in nominal domestic demand is arithmetically the product of the increase in demand for real goods and services and the increase in their prices. Causally, if nominal demand is growing much faster than real output can match it, inflation is inevitable. In the case of an economy as large as the United States, the surge in nominal demand will also affect the prices of supplies from abroad. The fact that policy makers elsewhere have followed similar policies will reinforce this situation. Yes, the Covid-induced recession has created significant slack, but not to this extent. The negative supply shock from the war in Ukraine has compounded all of this.
Yet we cannot expect this rapid growth in nominal demand to slow to around 4%, which is consistent with potential economic growth and inflation, at around 2% a year each. Nominal demand growth is well above interest rates. Indeed, not only has it reached rates not seen since the 1970s, but the gap between it and the 10-year interest rate is far greater than it was then.
Why would people watching their nominal incomes rise at such rates be afraid to borrow heavily at low interest rates, especially when many have balance sheets bolstered by Covid-era support? Isn’t it much more likely that credit growth and therefore nominal demand will remain strong? Consider this: even if annual nominal demand growth were to collapse to 6%, that would imply inflation of 4%, not 2%.
The combination of fiscal and monetary policies implemented in 2020 and 2021 has sparked an inflationary fire. The belief that these flames will be extinguished with a modest movement in interest rates and no increase in unemployment is far too optimistic. So let’s assume that this grim perspective is correct. Then inflation will fall, but perhaps only to around 4%. Higher inflation would become a new norm. The Fed would then have to act again or abandon its objective, destabilizing expectations and losing its credibility. It would be a cycle of stagflation – the result of the interaction of shocks with mistakes made by fiscal and monetary policymakers.
The political ramifications are disturbing, especially given a vast surplus of crazed populists. Yet the political conclusions are also clear. If the 1970s taught us anything, it’s that the time to stifle an inflationary surge is only just beginning, while expectations are still on the side of policy makers. The Fed must reiterate its determination to bring demand growth back to rates consistent with US potential growth and the inflation target. Moreover, it is not enough to say it. It should do it too.
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