The COVID-19 pandemic and Russia’s invasion of Ukraine have left most of the world reeling from the effects of stagflation. But as long as monetary authorities are taking pains to keep inflation expectations anchored, there is little reason to think that such conditions will become the new normal.
NEW YORK – A good case can be made that secular stagnation – sustained slower growth – is looming for most advanced economies, China, and many emerging markets and developing economies dependent on trade and foreign investment. Advocates of this view point to aging populations, deglobalization, climate change and biodiversity loss, rising inequality, and excessive debt, whereas optimists instead tout the potential of younger, dynamic countries and productivity-boosting technologies such as artificial intelligence, robotics, and bioengineering.
Yet even if secular stagnation is our destiny, it is not likely to take the form of secular stagflation, or what Nouriel Roubini calls the “Great Stagflation” (a combination of secular stagnation and persistent, long-term stagflation). Stagflation refers to materially above-target inflation, with unemployment above its natural level and output below its potential. But the more likely scenario for most advanced economies and China is many decades of secular stagnation with generally low inflation rates, interrupted by occasional one- or two-year episodes of transitory stagflation.
There are two distinct drivers of stagflation, both of which can be operative simultaneously. The first occurs when a negative aggregate supply shock boosts inflation while lowering output and raising the unemployment rate, as happened recently with the Russian war-driven spike in global commodity prices and the pandemic-driven disruption of supply chains. If the supply shock is temporary, or if aggregate demand adjusts downward to a permanently lower level of aggregate supply (with some help from tighter monetary policy), the above-target inflation will be transitory as long as inflation expectations don’t become unanchored.
The second type of stagflation occurs when inflation is too high for whatever reason (a negative supply shock or a positive shock to aggregate demand) and the central bank uses restrictive monetary policy – interest-rate increases, quantitative tightening (QT), forward guidance – to bring it down. Monetary-policy changes are known to affect underlying inflation with long, variable, and uncertain lags, whereas real (inflation-adjusted) GDP and unemployment tend to respond more swiftly.
Thus, European Central Bank Chief Economist Philip Lane estimates that the effect of monetary policy on inflation in the eurozone will peak after five quarters, while a 2013 meta-analysis by economists Tomas Havranek and Marek Rusnak finds that the transmission lag between an interest-rate shock and the general price level in advanced economies ranges from six to 12 quarters. If we account for the additional lags from compiling and publishing macroeconomic data, recognition of the problem, implementation of policy changes, and so forth, it is reasonable to conclude that stagflationary episodes will have a lifespan of 1-3 years, given appropriately restrictive monetary-policy responses.
In the current context, stagflation is likely to continue in the short term in developed countries and in China. Since the second quarter of 2021, much of the world has been experiencing materially above-target inflation (far above 2%), and though most central banks were late in tightening their monetary policies, medium- and long-term (five years and over) inflation expectations remain anchored. Today’s above-target inflation therefore should be squeezed out of the system within two years of monetary policy becoming restrictive, with the policy rate exceeding the neutral rate (typically taken to be 2.5%) and quantitative easing giving way to QT.
Consider the eurozone’s current situation. The ECB’s forecast, released on December 15, 2022, puts inflation at 8.4% in 2022, 6.3% in 2023, 3.4% in 2024, and 2.3% in 2025. The additional two years of materially above-target inflation are consistent with the fact that the Main Refinancing Operations rate is still in neutral territory (at 2.5%) and QT has not yet started.
The ECB’s forecasts for real GDP growth are 3.4% in 2022, 0.5% in 2023, 1.9% in 2024, and 1.8% in 2025, implying that stagflation is projected only for 2023. But this may be too optimistic. Additional conflict-driven stagflationary episodes are likely. Though the possibility of the Ukraine war going nuclear is not part of my own baseline scenario, it is a growing risk. Russian recourse to tactical nuclear weapons would deepen and extend the duration and scope of the conflict, not least by prompting additional open-ended economic and financial sanctions. In macroeconomic terms, it would amount to a further negative supply shock and a stagflationary force that could easily persist for one or two years.
Similarly, a Chinese invasion or blockade of Taiwan would have far-reaching global economic consequences. Though there is much uncertainty as to the timing, scale, scope, and duration of any military confrontation between China and Taiwan – not to mention the extent of any US military involvement – many now see a Chinese move against the island as a matter of “when,” not “if.” Systemically important supply chains would be severely disrupted by both the conflict itself and the ensuing economic and financial sanctions on China. Taiwan furnishes the world with a large share of the most sophisticated microchips, with TSMC alone accounting for nearly 50% of global production of chips smaller than ten nanometers.
Again, this kind of negative aggregate supply shock would produce a spike in inflation in most of the world, and disruptions to trade would likely cause a recession in China that could spill over to its (former) trading partners. The resulting stagflationary episode could easily last two years.
At horizons of two years and longer, above-target inflation becomes a policy choice. Monetary policy can affect underlying medium-term inflation by influencing aggregate demand and shaping inflation expectations. There is an effective lower bound on the policy rate when the central bank wishes to boost aggregate demand and inflation; but there is no similar binding interest-rate constraint when it comes to lowering the inflation rate.
Yes, the speed at which rates are raised, and at which asset purchases are reversed, will reflect financial-stability considerations. But monetary authorities in most advanced economies and China can and will control average inflation in the long run, and tolerating secular stagflation is not a choice they will make.
Willem H. Buiter: A former chief economist at Citibank and former member of the Monetary Policy Committee of the Bank of England, is an independent economic adviser.