The Fed must act now to ward off the threat of stagflation


Is there going to be a recession in the US and other leading economies? These questions have naturally arisen among participants at this year’s meeting of the World Economic Forum in Davos. This is, however, the wrong question, at least for the US. The right one is whether we are moving into a new era of higher inflation and weak growth, similar to the stagflation of the 1970s. If so, what might this mean?

The similarities are evident between the present “surprise” upsurge in inflation to levels not seen in four decades and that earlier era, when inflation was also a surprise to almost everybody, except the monetarists. That era was also characterised by war — the Yom Kippur war of 1973 and the invasion of Iran by Iraq in 1980. These wars, too, triggered jumps in oil prices, which squeezed real incomes. The US and other high-income economies experienced almost a decade of high inflation, unstable growth and weak stock markets. This was followed by a sharp disinflation under Paul Volcker, chair of the Federal Reserve, and the Reagan-Thatcher shift towards free markets.

Line chart of US inflation - annual % change in personal consumption expenditure deflator showing Inflation is at its highest in 40 years

At the moment, few expect anything similar. But a year ago few expected the present upsurge in inflation. Now, as in the 1970s, the rise in inflation is blamed on supply shocks caused by unexpected events. Then, as now, that was a part of the picture. But excess demand causes supply shocks to turn into sustained inflation, as people struggle to maintain their real incomes and central banks seek to sustain real demand. This then leads to stagflation, as people lose their faith in stable and low inflation and central banks lack the courage needed to restore it.

At present, markets do not expect any such outcome. Yes, there has been a decline in the US stock market. Yet by historical standards, it is still very expensive: the cyclically-adjusted price/earnings ratio of Yale’s Robert Shiller is still at levels surpassed only in 1929 and the late 1990s. At most this is as a mild correction of excesses, which the stock market needed. Markets expect short-term interest rates to stay below 3 per cent. Inflation expectations, shown by the gap between yields on conventional and index-linked treasuries, have even fallen a little recently, to 2.6 per cent.

Line chart of Cyclically adjusted price-earnings ratio on US stock market showing The US stock market also remains highly valued relative to earnings

In all, the Fed should be delighted. Movements in the markets indicate that its view of the future — a mild slowdown triggered by a mild tightening leading to swift disinflation towards target — is widely believed. Only two months ago, the median forecasts of Federal Reserve board members and regional presidents for 2023 were of growth of gross domestic product at 2.2 per cent, core inflation down to 2.6 per cent, unemployment at 3.5 per cent and the federal funds rate at 2.8 per cent.

This is immaculate disinflation indeed, but nothing like this is likely to occur. US supply is constrained above all by overfull employment, as I noted just two weeks ago. Meanwhile, nominal demand has been expanding at a torrid pace. The two-year average of growth of nominal demand (which includes the Covid-hit year of 2020) has been over 6 per cent. In the year to the first quarter of 2022, nominal demand actually grew by more than 12 per cent.

Line chart of Stock market value* as a % of GDP showing The US stock market remains uniquely highly valued

The growth of nominal domestic demand is arithmetically the product of the rise in demand for real goods and services, and the rise in their prices. Causally, if nominal demand expands far faster than real output can match it, inflation is inevitable. In the case of such a large economy as the US, the surge in nominal demand will also affect prices of supplies from abroad. The fact that policymakers elsewhere followed similar policies will reinforce this. Yes, the Covid-induced recession created significant slack, but not to this extent. The negative supply shock of the war in Ukraine has made all this worse.

Line chart of US yield curve on government debt (%) showing The yield curve has shifted down a bit as the stock market has tumbled

Yet we cannot expect this rapid growth in nominal demand to slow to the 4 per cent or so that is compatible with potential economic growth and inflation both at around 2 per cent annually, each. The growth of nominal demand is vastly higher than interest rates. Indeed, not only has it reached rates not seen since the 1970s, but the gap between it and the 10-year interest rate is vastly greater than then.

Why would people seeing their nominal incomes grow at such rates be afraid to borrow heavily at low interest rates, particularly when many have balance sheets made stronger by Covid-era support? Is it not far more likely that the credit growth and so nominal demand will stay strong? Consider this: even if annual growth in nominal demand were to collapse to 6 per cent, that would imply 4 per cent inflation, not 2 per cent.

Line chart of US inflation expectations (yield on 10-year conventional bond less yield on 10-year Tips, %) showing Implied expected inflation has fallen a little recently

The combination of fiscal and monetary policies implemented in 2020 and 2021 ignited an inflationary fire. The belief that these flames will go out with a modest move in interest rates and no rise in unemployment is far too optimistic. Suppose, then, that this grim perspective is correct. Then inflation will fall, but maybe only to 4 per cent or so. Higher inflation would become a new normal. The Fed would then need to act again or have to abandon its target, destabilising expectations and losing credibility. This would be a stagflation cycle — a result of the interaction of shocks with mistakes made by fiscal and monetary policymakers.

Line chart of Growth in US nominal domestic demand compared with 10-year bond yield (%, average over past year) showing The gap between growth of nominal spending and interest rates is unmatched in almost 50 years

The political ramifications are disturbing, especially given a vast oversupply of crazy populists. Yet the policy conclusions are also clear. If the 1970s taught us anything, it is that the time to throttle an inflationary upsurge is at its beginning, when expectations are still on the policymakers’ side. The Fed has to reiterate that it is determined to bring the growth in demand down to rates consistent with US potential growth and the inflation target. Moreover, it is not enough just to say this. It must do it, too.

martin.wolf@ft.com

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