In a recent note, Global Chief Economist Nathan Sheets and the Citi Research economics team study the possibility that central banks may have to battle stagflation—defined as the combination of persistently high inflation with growth that’s recessionary or significantly below trend—and what form a stagflationary episode might take.
The authors observe that the global economy is struggling under the weight of adverse supply shocks that have included COVID-19 challenges, supply-chain pressures and disruptions from the Russia-Ukraine war. The magnitude and persistence of these shocks suggest the possibility of further downside risks, including periods of stagflation. Having considered the probability of an outright stagflationary episode as low, the team decided to perform a more rigorous analysis to “kick the tires” on their assessment. Among the questions that interested them were to what extent supply shocks and ensuing stagflationary pressures were proving stronger than expected; and how confident they were that central banks would respond with the vigor necessary to meet the challenge.
Central Banks’ Vigorous Response
Sheets and his fellow economists believe the global economy’s adjustment to the supply shocks is likely to be painful, but add that they expect it will be less painful than what was seen in the 1970s and early 1980s. Then, central banks’ initial responses weren’t vigorous enough, a failing that caused inflation expectations to rise, bringing about even higher inflation and a more severe downturn. And the authors note that today’s central banks can’t directly reverse the supply shock but can only operate on the demand side, leaving them with a painful choice: accommodate the supply shock and accept high inflation, or extinguish the shock and risk recession.
The authors note that central banks have responded vigorously to the pandemic’s inflation challenges, though the effects of their responses have varied by region. In the U.S., vigorous monetary and fiscal policy shifted the aggregate demand curve out, reinforcing inflationary pressures. The euro area’s policies were less vigorous, leaving that economy facing a more “pure” supply shock that was then amplified by spillovers from the Ukraine conflict. And in Asia, shipping disruptions made it harder for firms to get goods to market, acting like an external demand shock. These differences have played out in core inflation rates: the most acute pressures have come in the U.S., followed by Europe and then Asia.
Two Stagflation Scenarios
The authors ponder two scenarios in which we might see full-blown stagflation similar to what happened decades ago. In the first, central banks fail to raise rates sufficiently or back away from restrictive policy too quickly. In the second, central banks do their best, but inflation expectations—whose underpinnings have proved elusive for economists—surge higher nonetheless.
Nominal Policy Rates | Nominal Policy Rates Deflated by Headline CPI Inflation
| Nominal Policy Rates | Nominal Policy Rates Deflated by Headline CPI Inflation |
 |
 |
|
© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission. Source: Citi Research, National Statistical Sources, Haver Analytics |
© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission. Source: Citi Research, National Statistical Sources, Haver Analytics |
The Citi economists conclude that central banks in developed markets haven’t tightened policy nearly enough to keep up with inflation’s surge, while their counterparts in emerging markets have done better at matching its pace. But they are more sanguine about inflation expectations, noting that they have remained fairly well anchored.
To these scenarios, the authors add a caveat: the possibility of a period of “transitionary stagflation,” a painful quarter or two in which growth slows before inflation drops. That could happen, the authors note, even if central banks remain aggressive and inflation expectations stay well anchored.
Revisiting Projections
Having assessed stagflationary scenarios, Sheets and team revisit their projections for global growth and global inflation—which have been lowered and raised, respectively—to consider what they imply for stagnation’s risks.
The Citi economists now expect the global economy to expand by 2.9% this year and 2.2% next year, a level of growth that looks soft and vulnerable to further shocks. Global inflation, meanwhile, is forecast at 7.1% in 2022 and 5.4% next year, well above its average in recent decades. Put those two forecasts together, and the global economy looks to be moving in a distinctly stagflationary direction. But the authors note that high inflation is unlikely to remain stubbornly persistent in the absence of an upward lurch in inflation expectations.
| DM: Change in 2023 Forecasts (2022 Aug vs. 2021 Nov) | EM: Change in 2023 Forecasts (2022 August vs. 2021 Nov) |
 |
 |
|
© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission. Source: Citi Research, National Statistical Sources, Haver Analytics |
© 2022 Citigroup Inc. No redistribution without Citigroup’s written permission. Source: Citi Research, National Statistical Sources, Haver Analytics |
So far there’s no evidence of such a change, which the authors see as a hopeful sign.
And it’s not the only one they see: Central banks are fully engaged in fighting inflation and seem committed to moving as needed, and the labor market’s performance continues to look strong, supporting growth and consumer spending. Taken together, such factors give Sheets and his fellow economists hope that inflation won’t take the kind of self-reinforcing turn seen in the late 1970s.
A global recession may be in the cards, the authors note, but they expect slowing growth and rate hikes will bring inflation back to target. The next six months will be pivotal in the fight to achieve that, with political pressures building on policymakers as the painful consequences for growth and spending become more evident. The authors expect rate hikes to gain traction and inflation to start to slow, but warn that policymakers and investors alike will likely encounter challenges and uncertainties ahead.
For more in depth analysis, please see https://www.citivelocity.com/t/r/eppublic/2T7e6
Citi Global Insights (CGI) is Citi’s premier non-independent thought leadership curation. It is not investment research. The comments expressed herein are summaries and/or views on selected thematic content from a Citi Research report. For the full CGI disclosure, click here.