What stagflation means for the West and the Middle East and some more and some more
Inflation is a leading contender for the economic term of the year so far, but now it is being challenged by the word recession. This reflects the prospect of stagflation — a period of inflation and slow growth — in an uncomfortable echo of the 1970s, when steep oil price rises led to inflation and recession in oil importing countries. Central bankers must find a path through these conflicting pressures, while investors now face bond routs and wobbly equity markets.
Several factors have pushed consumer price inflation in the West to levels not seen in four decades. Aggressive monetary interventions during the pandemic, often accompanies fiscal largesse, delivered a tsunami of cash, which triggered extraordinary stock and property price rallies. Disruptions to all manner of supply chains created further pressures, due to bottlenecks and higher transportation costs. Commodity markets have been upset by the Ukraine war and sanctions on Russia. US headline inflation rose to a 21st century record of 8.5 percent in March following a 1.2 percent increase from the previous month.
Large parts of current inflationary pressure are temporary. The COVID-19-related disruptions and other external shocks cannot last forever. But there is more to the story. US core consumer price inflation, which excludes volatile energy and food prices, hit an annual 6.5 percent in March. While markedly below the headline rate, this is a very high reading after more than two decades of annual price rises of around 2 percent.
In a tight labor market, this matters. The prospect of a wage-price spiral is distinct, with US salaries rising by more than 4 percent a year. To some extent, this may produce its own cure by attracting more people back into the workforce. Some relief may also come from technology-driven productivity gains. But should this wage inflation persist, it will feed into higher prices.
The longer-term outlook betrays growing anxiety. US inflation expectations over the coming 10 years have risen to more than 3 percent, the highest in two decades. The five-year inflation expectation in the eurozone is about to hit 2.5 percent. Both well above the historical norm, and are higher than the inflation targets of their respective central banks. When inflation is not stable, it can easily begin to accelerate.
As complex and multi-faceted as the current inflation problem is, central banks are approaching it with their standard toolkit, starting with unwinding pandemic-era interventions. But the response is arguably delayed and potentially all the more potent for that. The real question is whether this spells the end of the “lower for longer” interest rate era.
The fight against inflation is happening on multiple fronts. The hawkish turn in US central bank rhetoric is an attempt to reshape market expectations before it is too late. The Federal Reserve’s planned monthly balance sheet reductions of $95 billion will give rise
to a new capital market environment.
Already, more than $10 trillion worth of sub-zero debt has turned positive as bond prices have tumbled, leaving less than $3 trillion in negative territory. This will shift investor preferences in favor of less risky products while increasing the cost of high-yield debt.
The International Monetary Fund has warned of challenges for emerging market countries that boosted their lending from less than $65 trillion in 2016 to almost $100 trillion by the end of last year. With the growth of these nations projected to slow to 3.8 percent, the global outlook will moderate. The conflict in Eastern Europe and lockdowns in China will have a similar effect.
The Fed began rate tightening in March with expectation of the first eurozone hike in July. The market expects the Fed interest rate to move from 0.25-0.5 percent to 2.7 percent, maybe as much as 3 percent by the end of the year. Then, 3.5 percent looks possible by next June, while planned balance sheet reductions will effectively add some 0.75 percentage points to this.
High rates will begin to curb asset price inflation, which has run rampant during the pandemic. With house price growth stalling, the pressures for higher wages will weaken.Problematically, an unusually long period of cheap funding has resulted in unprecedented leverage around the world and the ability of borrowers to absorb sharp increases in debt servicing costs is in question. Not surprisingly, US consumer confidence today is lower than it was during the depths of the pandemic.
The goal of central banks around the world is a soft landing — something that historically has been easier said than done. One may also wonder whether central banks will actually stick to their guns. Preventing sharp falls in asset prices has become a key focus of monetary policy in recent decades — dating back to former Federal Reserve chair Alan Greenspan, who held the post from 1987 to 2006.
Let’s not forget that today’s inflationary pressures are unusual. Just as they shot up within a short period, it is possible that the mere prospect of aggressive tightening will take the air out of their sails sooner than expected, because of the reduced tolerance to higher rates. But even if rates rebound to close to 3 percent, they will effectively only revert to their pre-pandemic level.
This need not yet become very disruptive, even allowing for new post-pandemic vulnerabilities. With some of the one-off price pressures waning by then, cuts in inflation may come sooner than expected.
What does all of this mean for the Gulf region? Capital will become more expensive, albeit from a low base. Higher oil prices, fueling liquidity, will counter some of that while also encouraging lending. However, a potential retreat from ‘lower for longer’ interest rates validates the region’s long-standing aspirations around diversification and higher productivity. Slower global growth will cool the demand for oil, while costlier cash will push people to focus further on profitability and sustainability.
• Jarmo Kotilaine is an economist and strategist focusing on the Gulf region. He writes on issues ranging from economic development to changes within the corporate sector.