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A Whiff of Stagflation in the Economic Recovery

A Whiff of Stagflation in the Economic Recovery
 Eric Chaney
Senior Fellow - Economy

Downward revision for global growth

The most recent business surveys indicate a slump in the industrial recovery of major economies such as China, the US, Germany or France. The bad news seems to be global: companies have been caught off guard by the scale of difficulties in sourcing, delivering, or hiring labor. In the US, households are worried about a potential new wave of the pandemic.

Following a cycle of upward revisions until the summer, economists have now started to predict a slightly more pessimistic outcome for the upcoming months. Many forecasts now bring rising inflation rates to the scene. For instance, Goldman Sachs’ Jan Hatzius revised his forecast for the US economy in 2021 from 7% to 6%, without raising his 2022 outlook. The German Ifo Institute reduced its 2021 forecast by 0.8pp (to 2.5%), but raised its 2022 forecast by the same amount. In its September update, the OECD removed 0.2% from its 2021 growth projection for the G20 but revised figures upwards for Italy, Spain, and France. For China, Nomura's experts recently adjusted their 2021 forecast from 4.4% to a meager 3.0% year-on-year growth in Q4.

The main engine of the recovery is the end of drastic measures against the COVID-19 pandemic in the world's largest economies: the US, China, and Europe. The recent downward revisions do not necessarily call into question a global recovery scenario. In fact, the factors behind the slowdown appear more important than these marginal adjustments. The first one is the uncertainty surrounding the future evolution of the pandemic. The second factor concerns the extent of bottlenecks and shortages in key industrial and service sectors.

Heterogenous progress in vaccination campaigns increase the risk of mutations

Despite the acceleration of vaccination campaigns, the pandemic is still here. As of September 30, 6.27 billion doses of vaccines were administered. However, "only" 45.3% of the world's population received at least one dose. The production and administration of these vaccine quantities for a virus detected as recently as January 2020 is an unprecedented scientific, medical, and organizational achievement worth underlining. It should encourage modesty for those who criticize the global economic system as inefficient and unfair. Yet, we have to face the fact that the global vaccination rate is still far from the threshold of herd immunity. Only 6.8% of the 1.37 billion inhabitants of the African continent are currently vaccinated. More than the aggregate vaccination rate, it is regional heterogeneity that contributes to health uncertainties, and hence economic ones. Regional heterogeneity in vaccination rates increases the probability of new mutations of the Sars-cov2 virus.

Stranded container ships, risk of beer shortage in pubs

Since their first signs at the end of the spring, shortages and bottlenecks in production sectors have only tightened and multiplied. The current stranglehold on world trade is its most accurate representation.
While the revival of global demand greatly accelerated transpacific maritime traffic, the shipping industry is faced with important constraints. For instance, on 19 September, around 100 container ships were anchored off San Diego, unable to be unloaded due to a shortage of longshoremen. The situation was worse in Shanghai, where the number of ships at sea waiting to be loaded exceeded 150. In Rotterdam some 30 ships had to be anchored offshore because they could not dock - something unheard of for the Dutch, champions in port organization.

Since their first signs at the end of the spring, shortages and bottlenecks in production sectors have only tightened and multiplied.

A consequence of such trade blockages has been a drop in volumes. Its first sign was the 1% drop in world trade in goods by volume in July 2021, which is likely to have deepened further since. Another result of the blockage was a surge in prices: the average price of a container shipment is skyrocketing. According to the FBX index, between September 2021 and the end of 2019, its average price increased by a whopping 850%. Adding to this, the high demand for electricity and the low efficiency of renewable energies contributed to a dramatic increase in the spot price of fossil gas. 

Prices for gas increased by a factor of 3.4 on the US market, and by up to 7.9 on the English one.

According to the consultant AlixPartners, the current shortage of electronic components could last until mid-2022 and cost the global automotive industry more than $200 billion. The shortage of certain industrial gases such as CO2 could even cause English pubs to run out of beer supplies, yet another headache for Whitehall.

China is struggling with power cuts caused by high industrial demand, and the implementation of a carbon market to limit CO2 emissions. The combination of both of these elements convinced Nomura to revise downwards their Chinese growth forecast by 1.5 points for the fourth quarter of 2021.

Shortages even appear in the labor markets of countries with high unemployment rates. In its quarterly survey of French manufacturers, INSEE reported a record of 40% of companies that face production bottlenecks. At the same time, the capacity utilization rate was slightly below its historical average. The observed shortages therefore only concern supply and labor availability, for which 44% of companies reported difficulties. Furthermore, INSEE's monthly survey indicates that the French labor market has tightened further as there is a persistent disparity between optimistic hiring forecasts by companies and reality.

Inflation upwardly revised (almost) everywhere

The difficulties of the recovery stem from a lack of supply against strong demand. Unsurprisingly, this leads to soaring prices in most economies. We already mentioned sea freight and certain commodities, but an acceleration in inflation spread to a wide range of goods and services, which led the OECD to revise its inflation forecasts for 2022 for all countries. 

In the United States, inflation has stabilized at the high level of 5.3% in August. It is mostly driven by higher gasoline prices (+43%), used vehicles (+32%), automobiles (+7.6%) or transportation services (+4.6%). Core inflation, according to the measure used by the Fed, jumped to 4.1% in July. This is above its historical record high of 3.7% in December 1980. At the time, the Fed, chaired by Paul Volcker, let interest rates soar to 15% in order to ward off inflation, which had been creeping up during the 1970s. This caused a severe recession in the process.

An acceleration in inflation spread to a wide range of goods and services, which led the OECD to revise its inflation forecasts for 2022 for all countries.

In Germany, the inflation rate reached 3.9% in August - the highest level since December 1993, where it reached 4.3%. Back in 1993, the West German economy was overheating due to the generous financing of the German reunification. This had pushed the Bundesbank to raise its key rates to over 8%, plunging Germany and its close partners, including France, into recession.

In China, where bottlenecks and shortages are also present, inflation has emerged for producers, not for consumers. Manufacturers especially are facing a sharp rise in purchase prices of about 26% in August. Part of these increases are passed on to sales prices, which rose by 9.5%. For now, overheating is only affecting intermediate and capital goods. Despite the strong recovery in retail sales, which went up 18% since the beginning of the year, inflation is not affecting consumer goods. Moreover, the pig cycle is at its low point, marking a -55% decrease for pork in August. Overall, the inflation rate fell as low as 0.8% in August, well below the central bank's target. 

Paradoxically, while its own inflation is very low, China nevertheless contributes to global inflation via its exports. This is mostly the case for manufactured goods. For these goods, producers have no difficulty passing on their cost increases, given the strength of the global demand.


It took no less but downward-revised growth and growing inflation to dig out the good old "stagflation" from old economic textbooks. The term stagflation was initially coined in the 1970s when the world observed simultaneously a lasting slowdown in growth and an equally lasting acceleration in inflation. Prior to this, the two phenomena were considered to be mutually exclusive. Kenneth Rogoff, former chief economist of the IMF during a time of deflation, is among the economists concerned about the risks of stagflation. He points to the parallels between the current situation and the 1970s: deep supply shocks (caused by oil in 1973 and by protectionism today), pharaonic fiscal stimuli, and serious obstacles to monetary normalization due to accumulated debts. For his part, the economist Nouriel Roubini reckons that current shortages and bottlenecks will eventually disappear and that the global economy could then return to a high growth - high inflation situation. Yet, as Rogoff does, Roubini sees the dangers of negative supply shocks, such as protectionism, US-China decoupling, the accumulation of public and private debts, and aging populations. These could very well add up and fuel the "stagnation" part of stagflation. 

For the moment, this remains pure speculation and it is far too early to be certain about future growth and inflation. Olivier Blanchard, another former IMF chief economist, and Larry Summers, former World Bank chief economist, are more concerned about the risk of inflation than about a future slowdown in growth. Summers even considers the latter to have started more than ten years ago. However, many economists from younger generations criticize this way of thinking. For Gita Gopinath, current chief economist at the IMF, the primary risk would more be an early fiscal tightening that could lead to deflation. Obviously, we are still far from there.

Would central banks dare to react? 
Is China a future source of deflation?

Let us conclude by noting two symmetrical risks for the future of inflation.

First, the successful fight against the endemic inflation of the 1970s was in large part due to the resolute action of Paul Volcker. His decisions were considered irresponsible by a large part of the US Congress at the time, both on Democratic and Republican sides. If, in a few years' time, it was found that post-Covid inflation was not transitory, it is questionable whether the Fed or the ECB would fight it with the same obstinacy. 

Private and public debt increased to levels unknown in times of peace. In the event of a crisis, a good portion of the former would be transferred to the latter. The high debt provides a strong argument for executives to demand that central banks abstain from interventions. The risk of "fiscal dominance" is real and clearly inflationary.

Second, with the near bankruptcy of the developer Evergrande, China is at the beginning of a real estate crisis. This is reminiscent of the Japanese crisis of the 1990s. At the time, the bursting of the asset bubble, both in equities and in real estate, forced the private sector, households and corporates, to deleverage their balance sheets. This paved the way for a long period of mild deflation with inflation rates close to zero, and weak growth. The Chinese central bank, in close collaboration with the Bank of Japan, has been studying the Japanese case closely and decided on a liquidity injection on September 27. Unfortunately, awareness is no guarantee to take the right decisions at the right time. If for political or market reasons Chinese private companies were to engage in a race for debt clearance, the Japanese scenario would become more likely. Especially since today's China shares another characteristic with Japan at the time: demographic decline. This could make China a deflationary factor in the world economy. 



Copyright: JOEL SAGET / AFP

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