Inflation is already rising in many advanced economies and emerging markets, and there are signs of likely economic contraction in many advanced economies (the United States, the United Kingdom, Spain, Ireland, Italy, Portugal, and Japan). In emerging markets, inflation has – so far – been associated with growth, even economic overheating. But economic contraction in the US and other advanced economies may lead to a growth recoupling – rather than decoupling – in emerging markets, as the US contraction slows growth and rising inflation forces monetary authorities to tighten monetary and credit policies. They may then face “stagflation lite” – rising inflation tied to sharply slowing growth.
Stagflation requires a negative supply-side shock that increases prices while simultaneously reducing output. Stagflationary shocks led to global recession three times in the last 35 years: in 1973-1975, when oil prices spiked following the Yom Kippur War and OPEC embargo; in 1979-1980, following the Iranian Revolution; and in 1990-91, following the Iraqi invasion of Kuwait. Even the 2001 recession – mostly triggered by the bursting high-tech bubble – was accompanied by a doubling of oil prices, following the start of the second Palestinian intifada against Israel.
The ‘r’ word
Today, a stagflationary shock may result from an Israeli attack against Iran’s nuclear facilities. This geopolitical risk mounted in recent weeks as Israel has grown alarmed about Iran’s intentions. Such an attack would trigger sharp increases in oil prices – to well above €130 a barrel. The consequences of such a spike would be a major global recession, such as those of 1973, 1979, and 1990. Indeed, the most recent rise in oil prices is partly due to the increase in this fear premium.
But short of such a negative supply-side shock, is global stagflation possible? Between 2004-2006 global growth was robust while inflation was low, owing to a positive global supply shock – the increase in productivity and productive capacity of China, India and emerging markets.
This positive supply-side shock was followed – starting in 2006 – by a positive global demand shock: fast growth in “Chindia” and other emerging markets started to put pressure on the prices of a variety of commodities. Strong global growth in 2007 marked the beginning of a rise in global inflation, a phenomenon that, with some caveats (the sharp slowdown in the US and some advanced economies), continued into 2008.
An unlikely scenerio?
Barring a true negative supply-side shock, global stagflation is thus unlikely. Recent rises in oil, energy and other commodity prices reflect a variety of factors:
The weakening US dollar is pushing the dollar price of oil higher as oil exporters’ purchasing power in non-dollar regions declines.
Investors’ discovery of commodities as an asset class is fueling both speculative and long-term demand.
The diversion of land to bio-fuels production has reduced the land available to produce agricultural commodities.
Easy US monetary policy, followed by monetary easing in countries that formally pegged their exchange rates to the US dollar (as in the Gulf) or that maintain undervalued currencies to achieve export-led growth (China and other informal members of the so-called Bretton Woods 2 dollar zone) has fueled a new asset bubble in commodities and overheating of their economies.
Most of these factors are akin to positive global aggregate demand shocks, which should lead to economic overheating and a rise in global inflation.
Exchange rate policies are key. Large current-account surpluses and/or rising terms of trade imply that the equilibrium real exchange rate (the relative price of foreign to domestic goods) has appreciated in countries like China and Russia. Thus, over time the actual real exchange rate needs to converge – via real appreciation – with the stronger equilibrium rate. If the nominal exchange rate is not permitted to appreciate, real appreciation can occur only through an increase in domestic inflation.
So the most important way to control inflation – while regaining the monetary and credit policy autonomy needed to control inflation – is to allow currencies in these economies to appreciate significantly. Unfortunately, the need for currency appreciation and monetary tightening in overheated emerging markets comes at a time when the housing bust, credit crunch, and high oil prices are leading to a sharp slowdown in advanced economies – and outright recession in some of them.
The world has come full circle. Following a benign period of a positive global supply shock, a positive global demand shock has led to global overheating and rising inflationary pressures. Now the worries are about a stagflationary supply shock – say, a war with Iran – coupled with a deflationary demand shock as housing bubbles go bust. Deflationary pressure could take hold in economies that are contracting, while inflationary pressures increase in economies that are still growing fast.
Thus, central banks in many advanced and emerging economies are facing a nightmare scenario, in which they simultaneously must tighten monetary policy (to fight inflation) and ease it (to reduce the downside risks to growth). As inflation and growth risks combine in varied and complex ways in different economies, it will be very difficult for central bankers to juggle these contradictory imperatives.
Nouriel Roubini is Professor of Economics at the Stern School of Business, New York University, and Chairman of RGE Monitor
© Project Syndicate, 2008
