Policy against high inflation and the case of stagflation

High inflation incompatible with the target… It is known that the official inflation targeting of the Fed and many other role model central banks is stable within the 2% band. Considering the factors such as the global inflation pressure, the policy and supply conditions in developed countries, the fact that there was a deviation of at least 3 times, brought the rapid normalization phenomenon to the forefront in the monetary policies implemented. Therefore, despite the recession danger, it is possible that Central banks will not take a step back before tightening and put pressure on the economy in order to reduce inflation. When we look at the global geopolitical risks and the worsening supply conditions simultaneously, the risk of triggering a recession phenomenon increases. The coexistence of inflation and recession conceptually addresses the phenomenon of stagflation and the possibility of aggressive tightening policies that are tried to be applied in historical practices is mentioned.

The fight against inflation and the risk of stagflation… If we look at the June 2022 economic projections put forward by the Fed yesterday; It is seen that inflation will not decrease towards the 2% target band before 2024. The Fed revised its PCE inflation forecast for this year upwards from 4.3% in March 2022 to 5.2% in its June 2022 projection, while forecasting 2.6% for 2023 and 2.2% for 2024. The steps to be taken by the Fed show that there will be rapid early-stage interest rate increases this year, and in the coming years, first stagnation and then easing towards favorable financial conditions are observed. Of course, for this to happen, early-stage aggressive tightening should create an efficiency that will reduce inflation.

Comparison of US PCE inflation and Fed effective funding rate… Source: Bloomberg

The combination of stagnation in the economy with inflation is called “stagflation”. Stagflation has been effective in certain periods as an economic disease throughout the history of modern economics. Today, although the views on the prioritization of growth and inflation differ from each other, the prevailing view is that inflation should be reduced for sustainable growth dynamics. In this respect, it is considered a rational practice to bring price stability to the desired level by controlling monetary policy instruments, suppressing demand and secondary effects, then normalizing conditions and paving the way for growth.

Conclusion? The stagflation effect had an important reflection in the economy of the 1970s, when the devastating effect of oil prices was felt. At this point, the Fed’s keeping interest rates low on the implementation leg brought high inflationary pressure in the 1970s. When Volcker took over the Fed, he had to follow a hard prescription and raise interest rates sharply, enduring a shocking drop in growth while normalizing inflation in this way. If we compare yesterday’s statements with this perspective, the markets that entered the FOMC meeting by absorbing the 75 basis point increase showed some relief when Powell said that another increase of this magnitude could come, but this is not the new normal.

Just like in the high inflation period of the 70s, the fact that supply problems are not seen as the sole source of inflation causes Central banks to take a step back from reflationist policies. Therefore, despite the difficult recovery in the economy, inflation pressure leads Central banks to a more normal policy.

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Hibya Haber Ajansı