Bank for International Settlements warns of stagflation

The Bank for International Settlements advises central banks to act quickly and decisively to rein in inflation before it becomes entrenched.

Reserve Bank Governor Philip Lowe. The RBA has already forecast that inflation will hit 7 per cent late this year. Picture: AAP

The danger of stagflation looms large for the global economy, ­requiring central banks to act quickly and decisively before ­inflation becomes entrenched, according to the central bankers’ club.

In its 2022 annual report, the Bank for International Settlements says disruptions still linger from the pandemic, the war in Ukraine and soaring commodity prices, as financial vulnerabilities cloud the outlook.

The priority, according to the BIS, is to safeguard financial stability by restoring low and stable inflation and minimising the hit to economic activity.

“The key for central banks is to act quickly and decisively before inflation becomes entrenched,” general manager Agustin Carstens says.

“If it does, the costs of bringing it back under control will be higher. The longer-term benefits of preserving stability for households and businesses outweigh any short-term costs.”

The BIS says a repeat of 1970s-style stagflation is unlikely, mainly because of improved monetary policy and macroprudential frameworks and less reliance on energy. However, engineering a soft landing has historically been “difficult”, and there was a backdrop of financial vulnerabilities including high debt and overvalued asset prices which could magnify any slowdown.

Locally, the stagflation theme ran hot last week, with the release of minutes from the June meeting of the Reserve Bank board and a warning from governor Philip Lowe that widespread pay rises in the 4-5 per cent range would make it harder to return inflation to 2.5 per cent.

While pay rises above 3.5 per cent for a short period were possible, Dr Lowe said that a wage/price spiral would lead to more aggressive rate hikes and drive unemployment higher.

The RBA has already forecast that inflation will hit 7 per cent late this year.

The minutes of the June board meeting, which resulted in a 50 basis point hike in the cash rate to 0.85 per cent, say that rates are still very low for an economy with a tight labour market and facing a higher period of inflation.

If expectations of higher inflation were to become entrenched, the task of returning inflation to the target would become more difficult and come at a higher cost, with lower levels of economic activity and employment, according to the board.

Directors agreed that further rate increases were needed, and that the board was committed to “doing what is necessary” to bring inflation under control.

The BIS annual report also examines how price changes in specific goods and services can morph into more broadly based, persistently higher inflation.

Analysis shows that in high inflation environments, price changes for individual items like food or gas tend to exert a bigger and more persistent effect on overall inflation than they do when inflation is low.

It says that during transitions from low to high inflation, pressures tend to become self-reinforcing, as individual price changes start to matter more for people’s behaviour.

“The near-term challenge of ensuring low inflation coexists with the longstanding one of ­regaining future safety margins in macroeconomic policies,” Claudio Borio, head of the BIS monetary and economic department, says.

“Pressures on fiscal policy are mounting. This complicates the task for monetary policy and highlights the importance of ­reforms to support long-term growth.”

On the likelihood of a hard economic landing from rate hikes, the BIS says hard landings are more likely when financial vulnerabilities have already built up, making a growth slowdown more likely to trigger a recession.

Peaks in the financial cycle, it says, have tended to coincide with recessions since the early 1980s.

“For example, the average real policy rate at the start of tightening cycles that end in hard landings is 0.4 per cent, compared with 1.4 per cent at the start of those that end in soft landings,” the BIS says.

“Inflation is also on average higher before hard landings than it is before soft ones.”

Hard landing episodes also tend to involve increases in policy rates that play out over a longer time.

However, neither the average speed of a policy tightening, nor the size of overall tightening, seem to be associated with differences in the likelihood of hard or soft landings.

“This suggests that there is little to be gained in terms of output from a shallower and more drawn-out tightening path,” the annual report says.