EFG International : Is the global economy at risk of stagflation?

Growth and inflation
With energy and commodity prices surging, it is natural to ask if the global economy is at risk of a 1970s-style stagflation with growth around zero and high inflation. Shocks causing stagflation are rare events. To assess the probability of stagflation, it is therefore necessary to look at the historical record.

Three episodes stand out. The first of these is the collapse in growth to almost zero alongside a surge in inflation in 1974-75 and 1980-82. The second episode is the onset of the global financial crisis in 2009. On this occasion growth turned negative but inflation fell, indicating that a different shock was acting on the global economy. Finally, the third episode is the Covid crisis, with growth turning sharply negative in 2020 but inflation unaffected, and both growth and inflation being strong in 2021.

The risk of stagflation?
The very large oil shocks in 1974 and 1980, both of which can be thought of as aggregate supply shocks, appear to have triggered the single episode of stagflation in the last half century. How likely are such large contractionary aggregate supply shocks that reduce growth to zero to occur? Looking at the size, as measured by their 'standard deviation' of the estimated aggregate supply and demand shocks, it becomes possible to estimate how likely they are to happen.

The estimates indicate that the aggregate supply shock was 2.9 standard deviations large in 1974 and 2.3 standard deviations large in 1980. The table below shows that shocks that are one standard deviation large occur 19% of the time or on average every 5 years. Shocks that are two standard deviations large occur 6% of the time or on average every 17 years. Finally, shocks that are three standard deviations large occur 2% of the time or on average every 50 years. As discussed below, these define a benign, a benchmark and an adverse scenario.

While the war in Ukraine and the associated sanctions have led to a large shock to the global economy, a judgement must be made as to how large that shock is. While plainly large, it does not seem larger than the shock of 1974. At the same time, it does seem greater than a standard business cycle event.

Conclusions
Shocks leading to stagflation are rare. They are best thought of as contractionary aggregate supply shocks that restrict the economy's capacity to supply goods and services at the current price level. By raising costs for firms, they lead growth to fall to around zero and to higher inflation.

The war in Ukraine and the sanctions on the Russian economy plainly constitute a global aggregate supply shock. The question is whether it will be large enough to reduce growth to zero. That, of course, depends on how long the war and sanctions last, and how severe they will turn out to be. It is difficult to judge this at present.

One guess is that the impact will be consistent with a once-in-twenty years' supply shock. If so, the event may reduce growth and raise CPI inflation in the OECD area, both by about 2%. Growth will thus be low but positive. The effects are unlikely to be long-lasting unless, of course, the war and the sanctions are protracted. In that case growth may indeed fall to zero. Time will tell.

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