ING Monthly: Starting the great rotation

The latest surge in energy prices has not only dented the view that higher inflation is transitory, it has also brought back a term which spooked the economic world in the 1970s: stagflation.

Over the past 50 years, periods of accelerating inflation and slowing economic momentum have often been labelled as stagflation even though there has hardly ever been a real repeat of the kind seen in the 1970s.

Back then, stagflation was the result of several energy crises, acute logistical problems and a severe crisis of missing supply. As a result, economies contracted, unemployment surged to double-digit levels and currency regimes came under enormous pressure. Today, industrialised economies have become much less dependent on energy, both in terms of private consumption and in industrial production. As a consequence, any increase in energy prices, as unwelcome as it is for producers, consumers and central bankers, does not have the same economic impact as it did in the '70s. And of course, the current increase in energy prices, both in relative and absolute terms, and the slowing of economies is still nothing like the 1970s' experience. Let’s not forget that currently, most industrialised economies have already, or will soon, reach pre-pandemic levels of activity and unemployment is actually improving, not getting worse.

If the comparison with the '70s holds any lessons for the current situation though, it is simply in the challenge that policymakers, and particularly central bankers, face in dealing with accelerating inflation, mainly driven by higher energy prices. The '70s told policymakers that an ever-increasing wage-price spiral, if identified too late, can only be stopped by aggressive interest rate hikes.

Again, the current situation is not comparable to the 1970s but high headline inflation, surging energy prices, and arguably some global factors turning from disinflationary forces to inflationary ones, have made it harder for central bank doves to argue against any kind of policy normalisation. Admittedly, both the Federal Reserve and the European Central Bank seem to have decided for themselves that the cost of being behind the curve is lower than the potential cost of normalising prematurely. But there does seem to be some second-guessing of this theory.

It won’t be an easy process but we expect to see the start of a policy shift in the coming months. As most countries are now trying to live with Covid and economies are starting to reach pre-pandemic levels, labour market bottlenecks and inflation could trigger governments and central bankers to bring an end to emergency support measures, albeit gradually. However, the end of these measures will be immediately followed by questions about how best to support the recovery and any structural transition going forward. This is why we don’t expect a traditional exit but rather, a great rotation.