Joachim Nagel is the President of the Deutsche Bundesbank.
Flashy wallpaper, corduroy flares, long sideburns, disco and punk. The 1970s were a raucous, “in your face” decade. And for many, this decade is still attractive. Revivals come up again and again, whether in fashion or music.
Economically, however, the 1970s were a difficult decade, plagued by two oil crises, currency turmoil and rising unemployment. The combination of high inflation and a stagnant economy was so unusual that it even spawned a new portmanteau: stagflation.
Thus, the current situation, with its high inflation rates and its considerable risks for economic activity, awakens unpleasant memories. Was it the turn of the economy to experience a revival in the 1970s?
Parallels to this effect are indeed emerging.
Stagflation is usually triggered by unexpected events, or “shocks,” that reduce aggregate supply and cause prices to rise. The two oil crises of 1973 and 1979-80 were examples of supply shocks, which severely damaged economic growth, while driving up inflation. In the United States, the inflation rate reached almost 15% in March 1980.
Supply disruptions are also behind the current high inflation. But while the strong recovery from the pandemic-induced recession, coupled with expansionary macroeconomic policies, has played an important role in this, it is not the only driver here. Supply chains have been disrupted; commodity and transport prices soared.
Russia’s war against Ukraine has caused further shortages and price increases — especially for energy, but also for food. And it could get worse if the conflict escalates, as illustrated by a pessimistic scenario recently calculated by Eurosystem staff.
The labor market of some advanced economies appears to bear similarities to the environment in which stagflation first emerged: when labor is scarce, employees are better placed to push through high wage demands to compensate sharp price increases. And where wages increase significantly, there is also a risk that prices will increase further. It depends on the behavior of the companies. For them, it is easier to pass on the burden of higher costs by raising prices if demand is strong and other companies are also raising their prices.
But there are major differences between today and the 1970s. On the one hand, the energy intensity of advanced economies has more than halved since 1980. Energy price increases today are generally likely to cause less damage to the economy. Moreover, wage-price spirals no longer manifest as easily, especially since the bargaining power of trade unions is now much weaker. And so far, there have been few signs that such a spiral could emerge in the eurozone.
In this context, the role of inflation expectations and therefore of monetary policy is crucial.
In fact, the most important difference between the 1970s and today is that the independence of central banks is more respected and that greater importance is given to the objective of maintaining price stability. Moreover, central banks have gained credibility in their commitment to preserve it.
Faced with major political pressure to fight unemployment in the United States in the 1970s, the reaction of the Federal Reserve was too weak, too late. Interest rates ended up rising faster and higher than they should have if policy action had been taken in time. The Fed failed to control inflation and inflation expectations until it implemented a very restrictive monetary policy in the early 1980s, at the cost of a severe recession.
The main objective of the Eurosystem is to preserve price stability. Its independence, history of low inflation, and clear monetary policy strategy clearly distinguish where it is today from where the Fed was then. As a result, most experts now expect inflation rates to return to the Eurosystem’s medium-term target, and this anchoring of inflation expectations is a historic achievement.
However, history has shown that inflation expectations can lose their anchor if central banks are too slow to fight inflation, and we need to do better this time around.
While inflation expectations for this year and next year have risen sharply of late, longer-term inflation expectations are still close to our 2% target. We have to make sure things stay that way.
With the decisions taken on June 9, the Governing Council of the European Central Bank demonstrated its determination to bring medium-term inflation back towards its target. We must act decisively. Thus, the key rate hikes in July and September can only be the start. As things stand, a rapid return to a neutral level, or even beyond, is essential.
It’s unclear if flashy wallpaper, flares, or sideburns will make a return in the future. However, what we can and certainly must do is make smart policy decisions to prevent ‘reducing stagflation’.