Inflationary growth, stagflation or recession? Looking ahead

Inflation across the world has been rising. This has been caused by a rise in aggregate demand as the global economy has ‘bounced back’ from the pandemic, while supply-chain disruptions and tight labour markets constrain the ability of aggregate supply to respond to the rise in demand.

But what of the coming months? Will supply become more able to respond to demand as supply-chain issues ease, allowing further economic growth and an easing of inflationary pressures?

Or will higher inflation and higher taxes dampen real demand and cause growth, or even output, to fall? Are we about to enter an era of ‘stagflation’, where economies experience rising inflation and economic stagnation? And will stagnation be made worse by central banks which raise interest rates to dampen the inflation but, in the process, dampen spending.

Despite the worries of central banks, with inflation being higher than forecast a few months ago, forecasts (e.g. the OECD’s) are still for inflation to peak fairly soon and then to fall back to around 2 to 3 per cent by the beginning of 2023 – close to central bank target rates.

In the UK, annual CPI inflation reached 5.4% in December 2021. The UK Treasury’s January 2022 new monthly forecasts for the UK economy by 15 independent institutions give an average forecast of 4.0% for CPI inflation for 2022. In the USA, annual consumer price inflation reached 7 per cent in December 2021, but is forecast to fall to just over the target rate of 2% by the end of 2022.

If central banks respond to the current high inflation by raising interest rates more than very slightly and by stopping quantitative easing (QE), or even engaging in quantitative tightening (selling assets purchased under previous QE schemes), there is a severe risk of a sharp slowdown in economic activity. Household budgets are already being squeezed by the higher prices, especially energy and food prices. And people will face higher taxes as governments seek to reduce their debts, which soared with the Covid support packages during the pandemic.

The Fed has signalled that it will end its bond buying (QE) programme in March 2022 and may well raise interest rates at the same time. Quantitative tightening may then follow. But although GDP growth is still strong in the USA, Fed policy and stretched household budgets could well see spending slow and growth fall. Stagflation is less likely in the USA than in the UK and many other countries, but there is still the danger of over-reaction by the Fed given the predicted fall in inflation.

But there are reasons to be confident that stagflation can be avoided. Supply-chain bottlenecks are likely to ease and are already showing signs of doing so, with manufacturing production recovering and hold-ups at docks easing. The danger may increasingly become one of demand being excessively dampened rather than supply being constrained. Under these circumstances, inflation could rapidly fall, as is being forecast.

Nevertheless, as Covid restrictions ease, the hospitality and leisure sector is likely to see a resurgence in demand, despite stagnant or falling real disposable incomes, and here there are supply constraints in the form of staffing shortages. This could well lead to higher wages and prices in the sector, but probably not enough to prevent the fall in inflation.

Articles

• Inflation will probably melt away in 2022 – central banks will do far more harm trying to tackle it

The Conversation, Brigitte Granville (14/1/22)

• Stagflation and why it matters

The Week, Chas Newkey-Burden (1/10/21)

• Surging inflation could dwarf other issues in the political landscape as households feel the strain

Sky News, Ed Conway (19/1/22)

• Inflation is back, and there’s plenty more in the pipeline

The Guardian, Larry Elliott (19/1/22)

• UK inflation jumps to highest level in 30 years

Financial Times, Chris Giles (19/1/22)

• UK workers’ pay rises fall behind inflation amid cost-of-living crisis

The Guardian, Richard Partington (18/1/22)

• UK faces a pay squeeze – and higher interest rates look likely

The Guardian, Phillip Inman (18/1/22)

• Inflation: why it’s temporary and raising interest rates will do more harm than good

The Conversation, Muhammad Ali Nasir (22/11/21)

• Inflation: why it is the biggest test yet for central bank independence

The Conversation, Anton Muscatelli (14/12/21)

• Three more interest rate rises loom after Bank’s borrowing cost shock

The Telegraph, Russell Lynch and Tim Wallace (16/12/21)

• US Stagflation: The Global Risk Of 2022 – OpEd

Eurasia Review, Dan Steinbock (17/1/22)

• If prices keep rising, a nightmare scenario for the US economy is a real possibility

CNN, Paul R La Monica (12/1/22)

• Will inflation in the UK keep rising?

Bank of England (10/12/21)

Data

• Inflation forecast

OECD Data

• CPI annual rate

ONS

• Forecasts for the UK economy: a monthly comparison of independent forecasts

HM Treasury

• Inflation rates (by county)

Trading Economics

Questions