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Fear of stagflation can be overstated

The World Bank this week produced some headline-making pessimism, warning us all that stagflation stalks the globe. But, when you look at its forecasts, the picture is not quite as gloomy.

| 6 min read

The World Bank thinks the world will manage 2.9% economic growth this year, rising to 3% in 2023. The only major country it shows in recession is Russia.

The report pointed out that inflation is well above target in most places this year, with inflation expectations rising modestly in advanced countries. Its words talk of possible tough actions to stamp out inflation leading to recessions that do not appear in the GDP forecasts. They remind us of the difficult 1970s when stagflation last posed a serious threat. They then admit that today banks are stronger, making them more capable of handling some bad debts in the system.

This does not look like the 1970s all over again. The oil price hike in 1973 was much bigger than the one we have just witnessed from the dislocation of the Ukraine war. The price of oil soared from less than $3 to $12 in the spring of 1974. Banks indulged in advancing large amounts of credit in the early 1970s which started to embed inflationary pressures. Wages chased prices in a worrying wage/price spiral. Inflation on both sides of the Atlantic got more than 10% and stayed high. There was a nasty recession on the back of the oil crisis and rising interest rates to try to throttle back the credit. Double figure interest rates were common for periods of the 1970s on both sides of the Atlantic.

This week the European Central Bank (ECB) decided to make a major shift in its policy stance. It will continue creating more euro until the end of this month and will start raising interest rates with a 0.25% increase at its July meeting. It has watched as inflation has climbed to four times target in the zone and has attributed it mainly to the Ukraine war and the surge in energy and food prices. It now accepts that there is a more general inflation as well and it needs to alter its approach.

Southern states still face precarious times

The ECB is very nervous about possible pressures on the debt markets of the more heavily-indebted southern countries, so it is likely to go easy compared to the US. It said that it will still be reinvesting the full proceeds of bonds as they mature and if offers a special protection to Greek debt. It also said that that, if necessary, the central bank will buy more Greek debt than matures as part of the reinvestment programme. It will continue reinvesting from the special Pandemic Emergency Purchase Programme portfolio, as well as from the longer-term Asset Purchase programme.

Meanwhile, the yields on ten-year government bonds in the Eurozone have risen sharply. We suggested keeping clear of them all the time their yields were artificially low, supported by so much quantitative easing. The yield on the ten-year German bond was negative last year and is now at 1.43%. The Italian bond offers 3.75% today compared to the 1% last year. The Greek bond is now at more than 4%, up from 1 % last year. The ECB will be worried if the gap between German yields and the yields of the more financially-exposed southern countries widens too much. They see the Greek bonds as the most at risk.

Several of the economies will struggle to grow in the second quarter of 2022 as the real income squeeze limits spending by people and companies

ECB staff have also cut its growth forecasts that were released in March and raised its inflation expectations. This year, it now expect 2.8% growth with 6.8% inflation. This keeps it above stagflation but moving toward it more rapidly. For next year, it now reckons growth will be 2.1% and inflation 3.5%. These forecasts still look optimistic, with current inflation at 8.1% and with six countries in the zone at more than 10%. Several of the economies will struggle to grow in the second quarter of 2022 as the real income squeeze limits spending by people and companies. It is reluctant to pin down how far it might increase interest rates. It promises the first 25-basis-point rise for June and plan a further rise of 25bp or higher in September. The increase will be larger if inflation remains elevated or rises more. Thereafter, it keeps its options open.

ECB will pull its punches

Given the levels of state and commercial indebtedness, it will be reluctant to push rates too high. The system relies heavily on the transfer of money from surplus countries to deficit countries through the ECB currently at zero interest. They also wish to keep the costs of new borrowing by the highly-indebted countries at affordable levels and want to avoid large losses on their own substantial holdings of state bonds. The markets will probably want more reassurance about inflation and future policy before seeing these bonds as attractive.

The reactions of the four main money creating Central banks are now clearer. The Fed, Bank of England and the ECB have ended money creation and bond buying. The Fed wants to reverse some of its bond ownership, the ECB wishes to keep and replace its bonds and the Bank of England is considering policy. The US is the most hawkish and the ECB the most dovish. The Bank of Japan continues in the old world of zero interest rates and plenty of official bond buying as Japanese inflation remains very low by world standards and still does not concern them at around 2%.

The World Bank's words were scarier than its forecasts. Its expectations, like the ECB’s, may prove a touch optimistic as there are now strong forces beginning to slow the main economies. The European bond markets are having to catch up quickly with the new reality of more inflation this year and higher interest rates to start to control it. Equity markets worry over either inflation staying too high or the slowdown being too abrupt. The central banks continue to seek that middle path of a soft landing.

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Fear of stagflation can be overstated

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