SINGAPORE – The Bank for International Settlements (BIS) has warned that the risks of global stagflation – a combination of high inflation and an economic slowdown – “loom large” because of high and volatile commodity prices, the war in Ukraine and slower growth in China.
Central banks will need to act “quickly and decisively before inflation becomes entrenched,” Agustín Carstens, BIS general manager, said as part of the body’s post-meeting annual report on Sunday (June 26).
The Basel-based BIS, which is known as a “bank for central banks” and acts as a forum for international cooperation on monetary policy, said in the report that current conditions bear “an uncomfortable resemblance to past episodes of global stagflation.”
The world economy last experienced stagflation after the oil shocks of the 1970s both produced inflation and pushed many economies into recession. But the BIS points out that unlike in the past, stagflation today would occur alongside heightened financial strains, including stretched asset prices and high debt levels, a “historically unprecedented combination” which “could magnify any growth slowdown.”
Last month, consumer price inflation was running at more than 40-year highs of 8.6 per cent in the United States, a record 8.1 per cent in the Eurozone and multi-year highs in several other countries. While it is less elevated in Asia, even there it rose above central bank targets as the year progressed.
The BIS points out that “at a minimum, a spell of below-trend growth will be required to return inflation to acceptable levels.” But it adds that “a modest slowdown may not be enough – bringing inflation down may involve significant output costs. Even then, inflation may not fall quickly, given the intensity of recent price pressures.”
A confluence of forces fuelled the inflation, according to the BIS: a rapid recovery from the Covid-19 recession in early 2020, aided by massive monetary and fiscal support which boosted household incomes; a rotation of demand from services to goods and a failure of supply to keep up – especially for energy and commodities; and the war in Ukraine which has intensified price increases in these markets.
The BIS points out that inflationary pressures can be self-reinforcing and become entrenched because of behavioural changes. It warns that there are several indications that this is now happening: inflation expectations among households and financial market participants have started to increase. After a year in which real wages grew unusually slowly or declined, conditions for faster wage growth are in place. “As existing wage agreements expire, workers are likely to seek larger wage rises,” says the BIS. And the broadening of inflation pressures suggests that many firms have more pricing power than they had pre-pandemic.
Threats to growth
Inflation and especially commodity market disruptions will also weigh on growth, according to the BIS, by raising firms’ production costs and lowering supply. Financial stress in the form of high levels of public and private debt will magnify the slowdown.
So will weaknesses in China’s economy. Over the last two decades, China has accounted for about one-quarter of global growth and been a major source of demand for raw materials. But its growth will be weighed down by local lockdowns in response to outbreaks of Covid-19 in some cities, which are disrupting production networks. Problems in the real estate sector, which by some estimates accounts for about one third of China’s growth will also be a drag on the economy.
The BIS points out that China’s slowdown could be long-lasting because it is partly structural. The working age population has peaked and the potential for high productivity growth from reallocating labour to high productivity activities has diminished. The deflationary effects of China’s entry into the global trading system over the last 20 years may also be waning in the wake of wage and cost increases, which also adds to the risk of stagflation.
Difficult policy choices
Dealing with inflation presents challenges that policymakers have not faced in decades, at least in advanced economies, says the BIS. The most pressing challenge for central banks is “to restore low and stable inflation without, if possible, inflicting serious damage to the economy.”
Gradual increases in policy rates by less than inflation means that real interest rates (nominal rates minus inflation) will be negative, which would not keep inflation in check. So real rates would need to “increase significantly” – otherwise large and more costly rate hikes will be needed in future. But there is a trade-off that policymakers need to take into account. “Tightening too much and too quickly could inflict unnecessary damage,” the BIS points out.
It notes that achieving a soft landing – that is, bringing inflation under control without creating a recession – has historically proved difficult, and current conditions are in many ways unfavourable. In most countries inflation rates are already much higher than usual at the start of a cycle of monetary tightening and real and nominal policy rates much lower – “which suggests that a stronger tightening may be required to bring inflation under control.” But at the same time, high asset prices and debt levels mean that the output costs of tighter financial conditions “could be larger than in the past.”
In his testimony to a US Congressional committee last week, the chairman of the US Federal Reserve Jerome Powell said, a recession “is not our intended outcome at all, but it’s certainly a possibility.” In recent days, increasing numbers of economists have warned that the US economy is likely to tip into recession next year.