A stagflation scenario is not inevitable
Beyond what might appear to be a similar commodity price shock, there are differences resulting from far-reaching changes in monetary regimes, economic policy formation and wage relations. Analysing these changes can help us avoid the inevitability of a scenario comparable to the one that occurred 50 years ago.
Both the 1970s oil shock and the more recent price rises must be set in context.
The US monetary expansion of the late 1960s, together with an equally expansionary fiscal stance, had created excess demand and triggered a cycle of rising prices that preceded the 1973 oil price spike. This monetary cycle was imported into the major countries that today make up the eurozone and combined with strong fiscal expansion from 1968 to 1973 to fuel inflation. Aggregate demand was thus clearly overstimulated before the first oil shock, creating fertile ground for hyperinflation.
Over the course of the 1960s, central banks’ commitment to achieving their traditional goal of price stability was increasingly diluted in pursuit of the additional goal of maintaining a high level of employment. This erosion of central banks’ commitment to controlling inflation (and balance of payments deficits) lay behind the weakening and ultimate destruction of the Bretton Woods system and the emergence of persistently high inflation expectations.
The hardening of monetary policy in early 1973, in response to quickening inflation, preceded the oil shock and amplified its negative impact on growth. Meanwhile, fiscal constraints in 1974 amplified the negative effect of monetary policy. So it was not only the economic consequences of the upsurge in inflation that led to stagflation.
Monetary policy then changed direction several times over the course of the 1970s. This over-reactivity and lack of monetary policy consistency helped unanchor economic agents’ inflation expectations.
The removal of US price and wage controls in 1974 and automatic wage indexing mechanisms in a number of European countries amplified inflationary pressures and eroded competitiveness, exacerbating negative effects on growth. Indeed, wage growth had been sharply disconnected from productivity rates ever since the latter half of the 1960s.
Spiralling prices were also fuelled at the time by very energy-hungry consumption patterns and production processes, with energy-intensive industries accounting for a big chunk of GDP.
The backdrop for the current sharp rise in commodity prices is not at all the same, though there are notable differences on either side of the Atlantic.
There is no excess demand in the European economy; demand is still below pre-Covid levels, as shown by the significant excess savings that have built up in the region. Rising inflation before the war in Ukraine was linked to a supply shock caused by supply chain constraints. Transmission effects to the prices of all goods are evident, but there is no sign of transmission to wages.
In the eurozone, only 3% of private sector employees are covered by indexing mechanisms that automatically link their wages to an inflation index that includes energy prices; 18% are covered by mechanisms that formally take into account inflation excluding energy. Feedback loops are thus much more limited than they were in 1973.
There is now less capacity for energy price inflation to spread throughout the economy and affect economic activity. In 1973, it took one barrel of oil to generate $1,000 of GDP; today it takes only 0.4 barrels. The ECB estimates that the impact of an oil supply shock on global industrial production would be only half what it was in the 1980s and 1990s.
Since these inflation-fuelling mechanisms are now less powerful, the focus has shifted to the role of economic policy.
Economics textbooks suggest that higher prices due to a supply shock are supposed to indicate the scarcity of the product in question and redirect resources to “solve” the shortage. They do not signal a change in the overall capacity of production to satisfy more buoyant demand. This allocation problem is one central banks cannot solve. It would be pointless and counterproductive to try to control inflation in the short term. Central banks’ role, then, is supposedly to uphold confidence and ensure that the financial system is facilitating the smooth running of the economy. It would thus be a mistake to try to attack a supply problem with monetary restriction by reducing demand. Fiscal tools are a more appropriate means to achieve a happy medium between inflation andactivity: they can be targeted more accurately than monetary policy, at least as long as there are no second-round effects triggering a price/wage spiral and more persistent inflation. Targeted structural and fiscal policies aimed at unblocking supply bottlenecks and guaranteeing support for purchasing power in the absence of wage acceleration would thus be more relevant.
At the beginning of March, the ECB announced its intention to continue normalising its monetary policy so as to anchor expectations around its determination to stick to its price stability mandate. However, it has adopted a somewhat cautious stance, making it clear that the normalisation process depends on the future level of inflation and economic activity.
This position aims to strike a balance between inflationary fears and growth fears. Highly expansionary monetary policy was justified by a decade of well-below-target inflation and inflation expectations that had become unanchored (and moved downwards). Winding down of the central bank’s asset purchases and maintaining the size of its balance sheet still ensures an accommodative monetary policy stance. But what will the ECB do when inflation rises – as seems likely – above its forecast level (5.1% in 2022)? Everything will depend on what happens to inflation expectations and whether they risk becoming unanchored with inflation well above its target level.
Although short-term inflation expectations have risen, medium-term expectations are still well anchored (with five-year expectations at 2.2% in the eurozone and 2.7% in the US) and consistent with more symmetric inflation targeting.
The monetary policy missteps of the 1970s, characterised by immediate monetary restriction, can be avoided. The task facing the ECB is simpler: it does not have to deal with excess demand, few second-round effects are visible and inflation expectations are still anchored to its target.
Things are more complicated for the Fed: the US is further ahead in the economic cycle, signs of excess demand are showing, the labour market is tighter and constrained by a less dynamiclabour force, and wages have already responded to inflation. Furthermore, US growth will be hit less hard by the war in Ukraine, justifying a more aggressive monetary response. There is a risk that this response could be too aggressive, with negative implications for growth.
However, with a bit of luck and a sensible policy, we are not – contra the received wisdom – condemned to repeat history.