Big rate hikes needed as global stagflation risks loom, BIS warns

SINGAPORE – The Bank for International Settlements (BIS) has warned that risks of global stagflation – a combination of high inflation and an economic slowdown – are “prevailing” due to high and volatile commodity prices, war in Ukraine and slowing growth in China.

Central banks will need to act “quickly and decisively before inflation takes hold,” BIS Chief Executive Agustín Carstens said in the body’s annual post-meeting report on Sunday, June 26. .

The Basel-based BIS, which is known as a “bank of central banks” and acts as a forum for international monetary policy cooperation, said in the report that current conditions bear “uncomfortable resemblance to past episodes. of global stagflation”.

The world economy last experienced stagflation after the oil shocks of the 1970s both produced inflation and pushed many economies into recession.

But the BIS stressed that unlike in the past, stagflation today would occur alongside heightened financial stress, including stretched asset prices and high debt levels, a “historically unprecedented combination” that “could amplify any slowdown in growth.

Last month, consumer price inflation hit more than 40-year highs of 8.6% in the United States, a record 8.1% in the euro zone and multi-year highs in several other countries.

While it is lower in Asia, it even exceeded central bank targets over the year.

Stubborn inflation

The BIS stressed that “at a minimum, a period of below-trend growth will be needed to bring inflation down to acceptable levels.”

But he added that “a modest slowdown might not be enough – bringing down inflation can involve significant production costs. Even then, inflation might not come down quickly, given the intensity of the recent price pressures.

According to the BIS, a convergence of forces has fueled inflation: a rapid recovery from the Covid-19 recession in early 2020, aided by massive monetary and fiscal support, which boosted household incomes; a rotation of demand from services to goods and a failure of supply to follow – particularly for energy and raw materials; and the war in Ukraine, which intensified price increases in these markets.

The BIS pointed out that inflationary pressures can be self-reinforcing and entrenched due to behavioral changes.

He warns that there are several signs that this is happening: inflation expectations among households and financial market participants have started to rise.

After a year in which real wages grew unusually slowly or fell, the conditions for faster wage growth are in place.

“As existing wage agreements expire, workers are likely to seek larger wage increases,” the BIS said.

And widening inflationary pressures suggest that many companies have more pricing power than they did before the pandemic.

Threats to growth

Inflation and in particular commodity market disruptions will also weigh on growth, according to the BIS, by raising companies’ production costs and reducing supply.

Financial strains in the form of high levels of public and private debt will amplify the slowdown.

The same will be true for the weaknesses of the Chinese economy.

Over the past two decades, China has accounted for around a quarter of global growth and has been a major source of demand for raw materials.

But its growth will be weighed down by local closures in response to the Covid-19 epidemics in some cities, which are disrupting production networks.

Problems in the real estate sector, which by some estimates accounts for around a third of China’s growth, will also weigh on the economy.

The BRI pointed out that China’s slowdown could be long-lasting as it is partly structural.

The working-age population has peaked and the potential for high productivity growth from the reallocation of labor to high-productivity activities has diminished.

The deflationary effects of China’s entry into the global trading system over the past 20 years could also fade in the wake of rising wages and costs, which also increases the risk of stagflation.

Difficult political choices

Dealing with inflation presents challenges policymakers haven’t faced in decades, at least in advanced economies, according to the BIS.

The most pressing challenge for central banks is “to restore low and stable inflation without, if possible, inflicting severe damage on the economy.”

Gradual increases in policy rates below inflation mean that real interest rates (nominal rates minus inflation) will be negative, which would not keep inflation under control.

Real rates should therefore “rise significantly” – otherwise larger and more costly rate hikes will be needed in the future.

But there is a trade-off that policy makers need to consider.

“Tightening too hard too quickly could cause unnecessary damage,” BIS pointed out.

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