The combination of a) clear global slowdown signals and b) widespread bottle necks/labour shortages has raised fears of a ‘stagflation’ scenario for the global economy.

In this paper we look at how critical the situation is and which determinants will be important for whether we end up in a prolonged ‘stagflation’ scenario or whether it is simply a short term issue that will prove transitory. It is a supplement to our forecast for the global economy, which we outlined in Big Picture – Delayed delta recovery, 6 September 2021. Here we highlighted a downside risk scenario of stagflation with 30% probability.

While our baseline scenario is that inflation will fall back in 2022 due to lower commodity price inflation, and a soft landing in the global economy, we see a rising risk that labour shortages continue for longer and that potential output has been reduced. Challenges with the delta variant over the winter could prolong freight challenges and hamper labour supply further. A result could be rising wage pressures to levels not seen for a long time and a further increase in inflation expectations.

Economic stagnation and persistent inflation pressures would be a ‘stagflationary’ scenario that would require central banks to tighten policy despite weaker economies. The Fed would likely be patient in making a verdict on the persistence of higher inflation but would eventually tighten faster from 6M-24M if inflation expectations was to be de-anchored. We also expect the ECB to allow inflation to increase for some time but action could be taken in H2 2022 if inflation pressures stay elevated during H1 and inflation expectations increases further. In a follow-up piece we will look closer at the market implications of such a scenario.

‘Stagflation’ revisited

Recent economic data have highlighted the risk of a stagflationary scenario in which growth weakens more than expected but high inflation pressures continue. Being a combination of ‘stagnation’ and ‘inflation’ the best word to describe it in our view is stagflation, although this case of stagflation would be very different from the stagflation seen in the 1970’s where the label was first used (see box 1 at the end of the paper). A stagflation scenario is triggered by a negative supply shock, which reduces the potential output of the economy and thus pushes up inflation if demand is not ‘allowed’ to decline by policy makers through a tightening of policy. If economic policy even aims to lift demand with accommodative policy (as in the 1970’s) the inflation outcome is even worse (see box 2 for an explanation of the stagflation dynamics in a demand-supply diagram).

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