Inflation is hovering at levels many of us have never experienced and continues to rise. This raises serious concerns about what could happen if it isn’t brought under control soon.
While the threat of stagflation feels new to most of us, it’s happened in North America before and we got through it. It wasn’t easy, but an American central banker named Paul Volcker was willing to take the necessary but unpopular steps, more than four decades ago.
As this threat resurfaces in 2022, many are asking – could this be the summer that sees the return of Volcker-style rate hikes and stagflation, or might we be facing something else altogether?
We can’t have it both ways, or can we?
Stagflation is an undesirable combination of high inflation, slow economic growth, and high or rising unemployment. It’s also a real challenge for economic policy, since actions undertaken to reduce inflation usually worsen unemployment.
According to Tim Hicks, portfolio manager with Canso Investment Counsel Ltd, “the Phillips curve tells us that we can have low inflation or low unemployment, but not both.” The 1970s oil shock proved the Phillips Curve is not how things really work.
“The big oil shock, when prices quadrupled, was the precursor to the initial bout of stagflation and inflation becoming a permanent economic fixture, along with high unemployment. Stagflation also affected countries in Europe and some would argue they’ve never escaped it.”
Inflation is well above target almost everywhere in 2022, primarily due to artificially low interest rates, the government spending that came from the COVID-19 pandemic, and Russia invading Ukraine. Government handouts spurred increased spending on all manner of goods. This exacerbated the situation, as supply simply could not keep up with demand — for many things. Adding fuel to the fire were the massive increases in energy costs.
Paul Volcker: Inflation slayer
Paul Volcker was chairman of the U.S. Federal Reserve from August 1979 to August 1987 and successfully tackled very high inflation. He earned this moniker by making tough policy choices to get inflation under control, after it reached 15% in March of 1980. Just a few years later, it was below 3%.
But, as Hicks points out, “he didn’t have to deal with quantitative easing and unwinding a massive Fed balance sheet. The big question on everyone’s minds today is how this can be undone now that inflation is at 40-year highs.” And, we’ve never been here before.
The last time inflation was anywhere near today’s levels, Volcker raised interest rates swiftly and summarily, which adversely affected households and economies. The pace of the increases was unprecedented, as interest rates shot from 11.2% in 1979 to 20% by June 1981.
It was politically unpopular. The prime rate hit 21.5%. Unemployment exceeded 10%. Jimmy Carter lost his bid for a second term in the White House. A global recession ensued.
But, steep interest rate hikes were necessary in order to combat heightened inflation.
Inflection not reflection, is what’s needed now
“Volcker lifted interest rates above inflation, which lenders like because nobody wants to earn a negative real rate of return,” says Hicks.
“But, this appears to be the only way to fight inflation — by inducing a recession. We have to slow things down and get consumers to buy less stuff.”
So, where does that leave us now?
Current Fed chairman Jerome Powell is presumably hoping inflation comes down somewhat before the central bank has to raise rates much higher.
“The key point is Volcker had to raise interest rates to higher than the inflation rate,” he says.
“And even though central banks have been raising rates, they’re still nowhere close to inflation”, which was hovering around 8% in Canada and the U.S in late June 2022.
Willpower versus staying power
When it comes to how high and how quickly rates need to rise this time around, it’s anyone’s guess, but Hicks says it’s “pretty reasonable to expect rate increases to continue into 2023.”
Whether the Fed has the fortitude to do that remains unclear, given that “since the credit crisis, any negative effect on equity markets tends to prompt the Fed to halt increases or even announce additional cuts.”
What’s more, while the Fed is meant to be politically independent, it has a history of blurring the lines here. With the U.S. midterm election set for November 8, 2022 and U.S. President Biden facing low (and falling) approval ratings, the bureaucrats tasked with managing inflation may end up more focused on managing career risk.
That would lead to rate hikes being pushed out or suspended indefinitely, since individuals who lose their homes or jobs due to measures taken to tackle high inflation are unlikely to cast a ballot for the incumbent.
The central bank conundrum
“Central banks have the biggest conflict of interest in the world because their job is to keep inflation low, but the government benefits enormously from high inflation,” says Hicks. “It inflates away their debt.”
With inflation (at any level) borrowers get to repay lenders with money that is worth less than what it was worth when it was borrowed — which benefits those with debt.
What happens next?
Persistent supply disruptions and elevated commodity prices are a drag on economic activity and could cause stagflation. Unrelenting price pressures might end up requiring a lot more monetary tightening than what was anticipated when inflation first exceeded central bank targets and experts believed (and hoped) it would be transitory.
When it comes to fighting inflation, central bankers operate best with the benefit of hindsight. They usually raise rates too much or too quickly and then have to backpedal when a recession is triggered. Even if a global recession is averted, stagflation is still a very real threat to the global economic environment.
Volcker may not have been popular at the time, but he’s the only recent central banker who faced down inflation and won. Whether any current central bankers will one day earn that same distinction remains to be seen.
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