Stopping stagflation in 2022

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Why haven’t central banks applied more aggressively the instruments they possess to fight inflation? Especially since they were there before, in the 1970s. And, they have more instruments today than ever before. There are two important differences between now and then: first, the slowdown does not show in labour markets and, second, central bankers face a vast international financial system that is full of potential instabilities, but nobody can predict where exactly they will arise.

The current economic situation in many European countries, a coincidence of double-digit inflation rates and GDP growth at the brink of recession, has striking parallels with the two oil price shocks in the 1970s. The last stagflation ushered in a fundamental change in the economic policy paradigm, which foresaw a much more important role for monetary policy in stabilising the macro economy and demoted fiscal activism – that is, tax-and-spend to smooth business cycles.

Now as then, an accommodative macroeconomic policy, with low interest rates and fiscal stimulus packages, preceded an energy price hike that triggered a price–wage spiral given the ample liquidity. Once central banks ratcheted up interest rates after the President of the US Federal Reserve decided to end the inflationary spiral (the so-called Volcker shock in 1979), stagflation was the predictable result. It was no longer the usual choice between either a rock (inflation) or a hard place (unemployment), it was just the hard rock.

Elusive stability

Public debt ballooned even though governments largely gave up on fiscal pump-priming: tax revenue collapsed, and social expenditure shot up. It may seem surprising with hindsight, but this fiscal situation made governments ready to accept liberalised, integrated financial markets starting in the late 1980s. Bigger and deeper markets promised lower interest rates and thus lower debt servicing costs. Periodic bouts of exchange rate instability indicated, though, that more integrated financial markets are not necessarily stable financial markets.

The theme of unstable financial markets both links and differentiates the 1970s and the 2020s. Given that accommodative monetary policy and fiscal stimulus have been so much bigger now than back then, what has made central banks so reluctant to intervene with higher interest rates when the first signs of inflationary times appeared on the horizon? Volatility in energy prices, blocked supply chains and a rise in vacancies due to what became known as the Great Resignation all preceded the Russian invasion of Ukraine.

It is true that higher interest rates would push economies into recession. But that has never stopped central banks before to do what they feel they have to do in the face of serious inflationary threats. The supply chain disruption bequeathed by the pandemic might give cause to hesitate, but an accommodating monetary environment would not address underlying supply problems. And low unemployment could have actually emboldened central bankers as it keeps the social cost of a recession relatively low. Stagnation now is a decline in consumer spending and, even worse, in business investment. The explanation lies elsewhere, in financial markets.

The long shadow of the financial crisis

The inflation in markets for goods and services in 2022 was preceded by fifteen years of unprecedented monetary expansion, deliberately offering negative real interest rates for funds that financial institutions could obtain from central banks and then in wholesale markets. How used financial investors have got to this cheap funding is indicated by the hysteria and outright panic in equity and bond markets that incremental interest rate rises of half a percentage point created, with the prospect of a 5 percent Treasury fund rate. Given that inflation is close to 10 percent, this would amount to minus 5 percent in real terms, an inconceivable compensation for borrowing in peace times before 2008!

Monetary accommodation – here, an extended phase of very low interest rates – was absolutely necessary to tide economies over the systemic financial crises since 2008. There was always a good reason why it had to be extended. Emerging markets got into a tailspin whenever the US Federal Reserve wanted to raise its policy rate. In Europe, the sovereign debt crisis was a direct result of financial markets turning the table on governments that had just bailed them out (see chapter 6 of my book, The political economy of monetary solidarity: Understanding the euro experiment).

The financial markets that fifteen years of monetary accommodation have created are monstrous. Because banks, insurers and pension funds are now fairly strictly regulated, large parts try to evade and they live a shadowy existence, hard to catch with existing prudential instruments. The regulated part of the financial system must try and earn some of these excessive rates of return, by entering the world of crypto assets or using hedging instruments made for less volatile times.

The wrong metric of stabilisation

A conservative, business-friendly UK government just experienced the devastating effects of the monster raising its head. Prime Minister Liz Truss and her Chancellor were intent on rewarding high earners with a cut of the top income tax rate, presumably for their hard work of riskless financial investments. But borrowing for a tax cut spooked government bond markets. This hit pension funds, which had hedged against falling bond yields and now had to pay the hedge providers for the rapidly rising bond yields. The pension funds’ selling of bonds to meet the payments made the problem worse and forced the Bank of England to intervene in an emerging market-style rescue operation.

The monsters that they partly created is the real reason why central banks are unable to fight inflation resolutely now. Interest rate rises are a blunt instrument, and they know it. The real puzzle is why central banks have not already used more aggressively the macroprudential instruments they were given, for instance exceptional capital buffers so that they can deflate asset markets with targeted interventions. As long as flourishing asset markets is the going metric for successful stabilisation, the cost-of-living-and-doing-business crisis will linger on.


Waltraud Schelkle is Joint Chair for European Public Policy at the Department of Political and Social Sciences and the Robert Schuman Centre for Advanced Studies. Her research focuses on the political economy of monetary integration and on welfare state reforms – both seen through the lens of risk management and risk sharing.