Is stagflation set to make an unwanted return?

With the US Federal Reserve (Fed) and many other central banks in the process of tightening monetary policy rapidly to combat inflation, concern the world economy is heading for trouble is mounting.

Two ex-Fed officials recently warned US interest rates will have to rise more than expected and the outcome could be a recession. The remarks came after the International Monetary Fund said a prolonged slowdown in China would have substantial global spill overs. The warning came as it slashed its growth forecast for the world’s second biggest economy this year to 4.4 per cent, well below Beijing's target of around 5.5 per cent, as its ‘zero-COVID’ policy forces much of the country into lockdown, disrupting production and curbing consumption.

In Europe too, the risk of recession appears to be growing as surging energy and food bills hammer household budgets.

Little surprise then that a growing chorus of newspaper headlines is going as far as to warn stagflation, a long-lost economic phenomenon, is about to make an unwanted return.

The recent surge in inflation has been driven by a series of supply shocks, caused first by the pandemic, and more recently by the war in Ukraine and China’s zero-COVID policy. However, unless the world experiences further supply shocks, Michael Grady, head of investment strategy and chief economist at Aviva Investors, says suggestions leading economies are likely to suffer from persistent double-digit inflation alongside economic stagnation or recession are alarmist.

He points out that the combination of weaker output and sharply rising prices is highly unusual and has occurred only once before, in the 1970s, when two separate oil-price shocks (in 1973 and 1979) led to soaring inflation.

Over the past four decades, labour markets in most advanced economies have become much more flexible, while the threat of jobs being shipped abroad or automated has not gone away. That means there is far less scope for wages to continue rising in the face of slacker economic activity.

The fact that central banks have gained greater independence since the 1970s is another reason to doubt inflation will become entrenched. Among advanced economies, monetary policy needs to tighten fastest in the US, where the economy looks to be operating at, or close to, full capacity. Rapid job creation over the past two years has pushed the number of unemployed people per job opening to a record low.

By contrast, European economies are still operating some way from capacity and there is very little evidence of inflation beyond energy and food prices.

However, there are strong grounds for believing average inflation around the world will be appreciably higher over the next ten years than in the decade that followed the Global Financial Crisis and the one that preceded it. Investors need to adjust portfolios to account for both higher and more volatile inflation than they have grown accustomed to.

US interest rates may well rise higher than the market is currently anticipating. That could put pressure on the price of US government bonds, as inflation erodes the purchasing power of the fixed income they deliver.

As for equities, the combination of rapidly slowing growth, sustained high inflation and tighter monetary policy means stock selection will be critical.

Three points to remember

• Inflation is surging in economies around the world, triggered by the Ukraine war (which has disrupted the supply of key commodities) and rocketing demand as the global economy emerges from COVID-19
• Central banks are raising interest rates and reining in the special measures designed to help COVID-19-stricken economies combat inflation. These moves, combined with the price pressures facing consumers, are likely to cause economic growth to slow sharply
• However, it is unlikely that we are entering an era of stagflation, and there are measures investors can take to protect portfolios