After three decades of low inflation, most people could be forgiven for dismissing stagflation as an historical anomaly from the 1970s. However, fears are rising everywhere that this unwelcome prospect could soon be back.
Stagflation occurs when there is high inflation, low or negative real economic growth and increasing unemployment, a particularly traumatic trio for the economy. Periods of stagflation tend to overlap with recessions and often occur together with supply shocks (like oil price shocks) and are preceded by a period of loose monetary policy.
According to Phillip Braun of the Kellogg School of Management the primary cause of stagflation is not the oil shock but monetary policy response. In other words the root cause is when central banks do not adequately forecast how inflation and the real economy will respond to monetary tightening.
Monetary tightening and rising interest rates lead to households reducing spending and companies investing less. The aim is to rein in inflation and cool an overheated economy. Unemployment, economic growth and inflation do not respond immediately to a change in monetary policy and the effects are often not felt for two to three years. Inflation can, in particular, be sticky and continue to rise for up to three years as firms cut back on staff levels to meet reduced demand.
The question is how fast monetary contraction brings down inflation relative to causing economic growth to slow and unemployment to rise. It is a tricky balance with pandemic-induced supply chain issues running into the Russia-Ukraine war. Both of which are inherently inflationary.
Avoiding a hard landing
In New Zealand the Reserve Bank has indicated they will follow “the path of least regrets” progressively increasing the OCR in 2022 in higher increments than they had indicated earlier. Handled well, the central bank would account for the lag between rate hikes and declining inflation and start cutting rates again before it shows up in inflation figures.
Unfortunately, the odds of this happening are not great and the risks of a hard landing increase with each rate hike. According to Capital Economics since the late 1970s the US, UK and Europe have gone through sixteen tightening cycles and thirteen have resulted in a recession.
The war in Ukraine has made the situation even more fraught as it is likely to push inflation even higher but has also raised the risks to economic activity already weakened by the pandemic. As a result, “the path for a soft landing is narrow.”
On Monday Bridgewater Associate’s Ray Dalio warned the US was heading back to a period of 1970s-style stagflation. Ronald Reagan only brought the double-digit inflation of the time under control after sweeping into power in 1980 with a controversial economic policy platform of reduced government spending, cuts to taxes and regulations, and tightened monetary supply.
NZ’s high levels of household debt make things even trickier
The IMF in its preliminary “Article IV” report for 2022 raised concerns about high levels of (largely housing) debt leaving New Zealand particularly vulnerable to raising interest rates. Housing debt has risen alarmingly and is up by 29% since 2018 according to Stats NZ. This sensitivity means rates rises are more likely to slam consumer demand and set the foundations in place for stagflation. Capital Economics research found New Zealand was vulnerable to “even a modest rise” in interest rates.
The rates hikes may be short-lived, however. In January 2022 Ben Udy, Capital Economics Australia and New Zealand economist predicted falling house prices will mean the Reserve Bank will begin cutting rates again from next year.
As at December 2021 unemployment in New Zealand had dropped to 3.2%, its lowest rate ever. However, May will be a critical month in New Zealand when employment stats are released for the first quarter of 2022. The risks for stagnation are clearly high no matter how buoyant the labour market is right now. The economy held up remarkably well in 2021 but the forward-looking indicators suggest a gloomier outlook for the road ahead.