NEW YORK – I have been warning for several months that the current mix of persistently loose monetary, credit, and fiscal policies will excessively stimulate aggregate demand and lead to inflationary overheating. Compounding the problem, medium-term negative supply shocks will reduce potential growth and increase production costs. Combined, these demand and supply dynamics could lead to 1970s-style stagflation (rising inflation amid a recession) and eventually even to a severe debt crisis.
Until recently, I focused more on medium-term risks. But now one can make a case that “mild” stagflation is already underway. Inflation is rising in the United States and many advanced economies, and growth is slowing sharply, despite massive monetary, credit, and fiscal stimulus.
There is now a consensus that the growth slowdown in the US, China, Europe, and other major economies is the result of supply bottlenecks in labor and goods markets. The optimistic spin from Wall Street analysts and policymakers is that this mild stagflation will be temporary, lasting only as long as the supply bottlenecks do.
In fact, there are multiple factors behind this summer’s mini-stagflation. For starters, the Delta variant is temporarily boosting production costs, reducing output growth, and constraining labor supply. Workers, many of whom are still receiving the enhanced unemployment benefits that will expire in September, are reluctant to return to the workplace, especially now that Delta is raging. And those with children may need to stay at home, owing to school closures and the lack of affordable childcare.
On the production side, Delta is disrupting the reopening of many service sectors and throwing a monkey wrench into global supply chains, ports, and logistics systems. Shortages of key inputs such as semiconductors are further hampering production of cars, electronic goods, and other consumer durables, thus boosting inflation.
Still, the optimists insist that this is all temporary. Once Delta fades and benefits expire, workers will return to the labor market, production bottlenecks will be resolved, output growth will accelerate, and core inflation – now running close to 4% in the US – will fall back toward the US Federal Reserve’s 2% target by next year.
On the demand side, meanwhile, it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay. Today’s mild stagflation will then give way to a happy goldilocks outcome – stronger growth and lower inflation – by next year.