The Banking Executive Magazine - September Issue 2022

The Great Stagflation Coming after the stagflation (high in- flation and severe recessions) of the 1970s and early 1980s, the Great Moderation was characterized by low inflation in advanced economies; relatively stable and ro- bust economic growth, with short and shallow recessions; low and falling bond yields (and thus positive returns on bonds), owing to the sec- ular fall in inflation; and sharply ris- ing values of risky assets such as US and global equities. This extended period of low inflation is usually explained by central banks’ move to credible inflation-targeting policies after the loose monetary policies of the 1970s, and govern- ments’ adherence to relatively con- servative fiscal policies (with meaningful stimulus coming only during recessions). But, more impor- tant than demand-side policies were the many positive supply shocks, which increased potential growth and reduced production costs, thus keeping inflation in check. During the post-Cold War era of hyper-globalization, China, Russia, and other emerging-market economies became more integrated in the world economy, supplying it with low-cost goods, services, en- ergy, and commodities. Large-scale migration from the Global South to the North kept a lid on wages in ad- vanced economies, technological in- novations reduced the costs of producing many goods and services, and relative geopolitical stability al- lowed for an efficient allocation of production to the least-costly loca- tions without worries about invest- ment security.1 But the Great Moderation started to crack during the 2008 global finan- cial crisis and then during the 2020 COVID-19 recession. In both cases, inflation initially remained low given demand shocks, and loose monetary, fiscal, and credit policies prevented deflation from setting in. But now in- flation is back, rising sharply, espe- cially over the past year, owing to a mix of both demand and supply fac- tors. On the supply side, the backlash against hyper-globalization has been gaining momentum, creating oppor- tunities for populist, nativist, and pro- tectionist politicians. Public anger over stark income and wealth in- equalities also has been building, leading to more policies to support workers and the “left behind.” How- ever well-intentioned, these policies are now contributing to a dangerous spiral of wage-price inflation Making matters worse, renewed pro- tectionism (from both the left and the right) has restricted trade and the movement of capital. Political ten- sions (both within and between countries) are driving a process of reshoring (and “friend-shoring”). Po- litical resistance to immigration has curtailed the global movement of people, putting additional upward pressure on wages. National-security and strategic considerations have fur- ther restricted flows of technology, data, and information. And new labor and environmental standards, important as they may be, are ham- pering both trade and new construc- tion. This balkanization of the global economy is deeply stagflationary, and it is coinciding with demo- graphic aging, not just in developed countries, but also in large emerging economies such as China. Because young people tend to produce and save, whereas older people spend down their savings, this trend also is stagflationary. The same is true of today’s geopolit- ical turmoil. Russia’s war in Ukraine, and the West’s response to it, has dis- rupted the trade of energy, food, fer- tilizers, industrial metals, and other commodities. The Western decou- pling from China is accelerating across all dimensions of trade (goods, services, capital, labor, technology, data, and information). Other strate- gic rivals to the West may soon add to the havoc. Iran crossing the nu- clear-weapons threshold would likely provoke military strikes by Is- rael or even the United States, trig- gering a massive oil shock; and North Korea is still regularly rattling its nuclear saber. Now that the US dollar has been ISSUE 165 SEPTEMBER 2022 the BANKING EXECUTIVE 29