By V Thiagarajan
The International Monetary Fund (IMF) recently slashed its forecast for global economic growth by nearly a full percentage point citing Russia’s war in Ukraine, and warned that the world must brace itself for an economic slowdown as well as a burst in inflation.
The IMF expects inflation to remain elevated throughout the year, projecting it at 5.7% in advanced economies and 8.7% in emerging markets. Rising prices around the world show no signs of abating, the IMF said, even if supply chain problems ease. As such, we can expect the global economy to endure a painful period of lower growth and higher inflation during this year as well as next. While the accuracy of forecasts by the IMF remains debatable, there are other economic forecasts, which have broadly been on the same lines.
The Peterson Institute for International Economics expects global growth to decline from a rapid 5.8% in 2021 to 3.3% annually in 2022 and 2023. According to the Bank for International Settlements, more than half of emerging economies have inflation rates above 7% and 60% of “advanced economies,” including the US and the Euro area, have inflation over 5%, the largest share since the 1980s.
We all accept that this is indeed another moment of reckoning for the global economy. It is ironic that all the economic crises in this century, be it the GFC 2008 or the Pandemic 2020, have been addressed by coordinated action both from fiscal and monetary policy across the globe whereas the responsibility for containing the current spell of inflation has been shouldered only by the central banks.
According to the Bank for International Settlements, more than half of emerging economies have inflation rates above 7%, and 60% of ‘advanced economies,’ including the US and the Euro area, have inflation over 5%, the largest share since the 1980s
Monetary policymakers have begun using their monetary policy tools by raising rates and pruning their balance sheets or by cautioning the markets about their upcoming policy decisions whereas the fiscal authorities have yet to take any remedial measures.
Tale of Two Variables
The two most critical variables in any economy are growth and inflation. There are secular and cyclical trends that determine the trajectory of growth as well as inflation. The level of growth or inflation is not as important as the direction because the economy and asset markets are relative, not static. It is imperative to have a firm understanding of these secular and cyclical trends.
Markets commonly mistake cyclical changes in the economy for structural or secular changes, which leads to poor asset allocation decisions. You will always have the highest probability of success with an asset allocation decision when aligned with both the secular and cyclical economic trends.
Too much money has been chasing information technology projects and driven mostly by technology-related companies, global equity markets have grown to an aggregate amount of almost $120 trillion. That is 11 times the size of the overall natural resource industries worldwide
At present, there is a perceptible risk for the global economy where this cyclical trend of high Inflation accompanied by low growth might become a structural trend for this decade.
Demand and Supply
Inflation is typically the result of an imbalance in supply or demand. The recent surge in inflation has endured, it has triggered a series of narrative shifts — price increases were initially deemed to be transitory, then they were tied to developments in specific sectors and changes in consumption patterns, and now inflation is acknowledged to be a broad-based phenomenon.
Since sectors display heterogeneous, persistent and transitory price movements, a complementary perspective distinguishes between changes in the trend that are common across sectors and changes that are idiosyncratic, or sector-specific.
Sector-specific movements may have been relevant at the beginning of the pandemic but are currently playing a smaller role than common dynamics. Sometime in the second half of 2021, the common persistent components came to dominate the evolution of the trend and today it stands as a significant driver and this inflation is likely to be persistent as well as broad-based.
What makes this period of inflation somewhat unique, however, is that the economy is experiencing pressure from both supply and demand factors. Though we may disagree on their relative contribution, we should not dismiss either.
On the supply side, we have the supply chain disruptions that have dominated the news. In part, this is due to how pandemic mitigation policies have interacted with production, commerce and transportation. These factors, which were considered transitory, have proved persistent.
Germany’s hyperinflation of the early 1920s provides a textbook example of runaway prices arising from intractable social divisions. Weimar Germany was a weak democracy, dominated by powerful cartels and riven with social conflicts between powerful groups: organised labour, agricultural interests and industry
Driven mostly by technology-related companies, global equity markets have grown to an aggregate amount of almost $120 trillion. That is 11 times the size of the overall natural resource industries worldwide. Too much money has been chasing exciting information technology projects while essential parts of the economy have been completely forgotten, especially natural resource industries. It is obvious that the underinvestment of the last decade has been leading to tighter supplies at a time when the demand has been recovering.
On the demand side, the economic rebound in advanced economies has been surprisingly rapid, outpacing the expectations and setting this recovery apart from the aftermath of previous recessions. Moreover, there is reason to expect demand to remain very strong on account of low unemployment in advanced economies, which means that inflation will persist. It is far more likely that the increase in demand exceeds what the economy can produce, leading to higher prices.
High inflation means different things to different generations. To the earliest baby boomers, the term conjures memories of the double-digit increases of the mid-70s to early-80s and sky-high mortgage rates. For subsequent generations of inflation watchers, central banks’ success in keeping inflation near or below their target has made today’s rates look shocking. This is so as the central banks and economy have repeatedly followed the same predictable cycle at least since 1990s.
As economic activity heats up following a recession, the central banks slowly raise rates. The yield curve flattens as economic growth wanes. The flattening yield curve ultimately inverts, and the central banks stop raising rates in a year or two. As recession hits, the central banks lower rates, the yield curve steepens, and the cycle starts anew. So the markets as well as governments expect the central banks to act in accordance with the business cycle and temper inflation.
Inflation is always seen as a trickle to the top and the political leadership normally pays the cost for this pain. Germany’s hyperinflation of the early 1920s provides a textbook example of runaway prices arising from intractable social divisions. Weimar Germany was a weak democracy, dominated by powerful cartels and riven with social conflicts between powerful groups: organised labour, agricultural interests and industry.
In his 1971 State of the Union Address, Richard Nixon noted that inflationary psychology had “gripped our nation so tightly for so long.” Nixon tried to stop inflationary psychology by instituting wage and price controls, but his plan failed. His successor, Gerald Ford, organised the ‘Whip Inflation’ Now campaign, urging disciplined spending habits and personal savings. That didn’t work, either.
The last two decades witnessed a surge in public debt worldwide. In advanced economies, the public debt burden soared from about 70% of GDP in 2001 to above 120% of GDP in 2021
This cycle of inflation, which started in 1965, didn’t end until the early 80s, when then-Federal Reserve Chair Paul Volcker increased interest rates from ~10% to ~20%, crashing the economy into a recession in the process.
The governments and central banks always think that they have the power to crush inflation but, in fact, they do not possess any magic wand to bring down the price levels but to wait out for the base effect to kick in for the rate of change of prices to come lower.
What Lies Ahead
An important concern is where inflation will be headed over the medium and long run. Different theories suggest different mechanisms for long-run inflation and hence possibly arrive at different answers.
Subscribers to New Keynesian theory, popular among central bankers, view long-run inflation as the product of inflation expectations. These expectations are “anchored” by monetary policy, typically around the central bank’s own inflation target. This is why central banks are concerned about long-run inflation expectations: They act as barometers of their credibility.
In contrast, monetarists and subscribers to the fiscal theory of price level attribute long-run inflation to the growth rate of government nominal liabilities (money and debt). Critically, long-run inflation depends on who controls this growth rate.
Nixon tried to stop inflationary psychology by instituting wage and price controls. His successor, Gerald Ford, organised the Whip Inflation Now campaign, urging disciplined spending habits and personal savings. Both didn’t work
Changes in the fiscal stance have been an important driver of inflation during the past 70 years. When budget deficits have widened, annual inflation has pushed close to or above 5%, especially after the US went off the gold standard in 1971. The last two decades witnessed a surge in public debt worldwide. In advanced economies, the public debt burden soared from about 70% of GDP in 2001 to above 120% of GDP in 2021. Higher debt levels drain an economy of productivity if the debt is not being used to generate a future income stream to repay both the principal and the interest. If the debt does not generate a lasting income stream (unproductive debt), then future income must be diverted from productive use to repay the principal and the interest
The correlation is not one to one — however, it is almost always the case that when fiscal slippages occur, the central banks end up monetising a larger amount of government debt. If the central bank accommodates fiscal policy, then it is the fiscal authority that determines the growth rate of government liabilities and, thus, long-run inflation. This situation is known as “fiscal dominance.” Alternatively, the fiscal authority may curb its expansionist impulses if it believes the central bank will do whatever it takes to keep inflation within its target.
Setting the fiscal dominance scenario aside, New Keynesian, monetarist and the fiscal theory of the price level theories agree that the central banks’ credibility is critical for the control of long-run inflation. Depending on one’s view, this involves managing long-run inflation expectations or avoiding situations in which the fiscal authority challenges the central banks’ willingness to defend the inflation target. High inflation currently poses a risk to this credibility. It would be very costly if central banks were to lose the credibility of their inflation target and conduct policy to regain it.
In summary, given the toxic interaction with already very high debt levels and rising inflation expectations, the central banks’ plans could easily be derailed and their monetary tightening may not sustainably bring down inflation. Eventually, it would be realised that this spell of inflation may not mean reverting in nature so long as the public debt is at elevated levels. And it can be controlled only by pruning the debt levels of the governments.
(The author is an Independent Market Expert)