By Karim Maher Abadir, Emeritus Professor of Financial Econometrics, Imperial College London, and Gabriel Talmain, Emeritus Professor, Glasgow University, formerly Daniel Jack Chair of Political Economy
Submission Accepted On: 14 June, 2022
For almost a year now, we have witnessed the combination of stagnation and inflation, known as stagflation. It seems to have taken many analysts by surprise, but it was clear that its seeds were being sown as early as June 20191. Furthermore, in the summer of 2021, International Banker2 invited an article about it, explaining why it was going to happen and what its consequences would be. All of its predictions have materialized—for the macro-economy and also stock prices. These predictions are based on a new macro-economic model published in 2002 and its implications for macro and financial trends and cycles3.
The central banks were too late and initially too timid in their reactions to stagflation, and one of the consequences has been inflation getting out of hand, both in size and persistence. The economic situation has evolved: Policymakers are now facing the risk of overshooting their targets if they stick to their declared responses, which are already underway.
Stagnation is defined as low but positive growth of gross domestic product (GDP), while recession is negative growth. Prior to the economic shock caused by the war in Ukraine, the dynamics of our model indicated stagnation. As of March 20224, this was updated to recession in Europe and possibly also in the United States, depending on what policymakers did there. Given the declared (and partly implemented) policies so far, we also expect the US to be entering a recession. The graph illustrates the trends in their GDPs: After the (substantial) blip caused by COVID-19, these bounce-backs have been tailing off, especially now that the fiscal and monetary stimuli are being withdrawn.
Fiscal policy has turned restrictive, as stimulus has been withdrawn and effective tax increases are taking place, whether explicitly (as in the United Kingdom) or implicitly. Some of these increases have resulted from inflation: Thresholds in tax brackets remain the same while inflation pushes nominal incomes higher. In addition, the inflation burden on consumers has restricted their spending in real terms; for example, US retail sales went up 0.9 percent month-on-month in April, but the consumer price index (CPI) was up 1.2 percent for the same period: In real terms, retail sales have declined. (After the writing of this article, the Census Bureau released new retail sales figures showing a contraction for May 2022 as well as a downward revision for April 2022. These figures validate our forecast).
More recently, monetary policy has also become more restrictive in the US and the UK, and the eurozone is set to follow suit during the July meeting of the European Central Bank (ECB). The saying that “central banks can’t control commodity prices” was a dangerous excuse for past inactions: commodity prices peaked some time ago—many have even declined—and the continuing increase in prices can’t be blamed on this. (In any case, central banks can affect the demand for commodities—hence their prices—via the impact of rate rises on demand or on local prices through exchange rates: The supply side isn’t the only force determining prices. They also affect expectations of future prices and inflation.) However, the declared position of the US Federal Reserve (the Fed) will lead to overshooting of interest-rate rises beyond what is needed. There’s no point in fighting yesterday’s battles with the onset of a recession.
Our forecasts are typically for a six-month period. What policymakers do in the meantime, as well as further shocks from the war in Ukraine and other unknowns, will affect our updated estimates. We caution against trying to classify variables such as inflation as transient or not (whatever these vague classifications mean). They are not predetermined regardless of events and policies (they are “endogenous,” not “exogenous”, in technical jargon). For example, US inflation is persisting, but the overshooting interest rates imply that this will not remain so.
Fiscal and monetary policies do not need to push in the same direction of tightening. Actually, a subtle combination can tackle rising inflation and slowing growth. Jan Tinbergen and Robert Mundell (both Nobel laureates) were pioneers in teaching us the matching of policy instruments to targets, inflation and growth here. The optimal mix of fiscal and monetary policies is now different from the 1970s. The recent demand shock to consumers is substantial and will need to be counteracted with fiscal policy for another year or so (especially in Europe, where consumers received less stimulus payments than in the US) before governments reduce their deficits and tackle their mounting debts. Monetary policy should go on tightening but stop earlier than declared in the US, while the ECB has yet to tighten.
1 Twitter: Karim Maher Abadir @kmabadir.
2 International Banker: “Stagflation, Reincarnated,” Karim Maher Abadir, October 14, 2021.
3 SSRN (Social Science Research Network): “Beyond Co-Integration: Modelling Co-Movements in Macro Finance,” Karim Maher Abadir and Gabriel Talmain, January 21, 2012.
4 Twitter: Karim Maher Abadir @kmabadir.