Readers of a certain age will be familiar with the phenomenon of ‘stagflation’, a term coined by the Conservative MP Iain Macleod in 1965 to describe the UK economy, which at the time, and through much of the 1970s, was afflicted by both stagnant activity and elevated inflation.
Somewhat worryingly, the word is now cropping up again in the financial press. We have argued that structural changes over the last 50 years suggest that a return to 1970s-style inflation is unlikely in developed economies (see our commentary of April 2021). However, the newsflow in recent weeks has had a somewhat “stagflationary feel” to it, with real economy activity data generally disappointing consensus forecasts, while measures of inflation (producer prices, consumer prices etc.) have generally surprised on the upside1. The UK economy barely grew in July2, while in the US, a streak of lacklustre economic releases has seen forecasts for third quarter GDP growth downgraded sharply3. Meanwhile, headline inflation stands at 5.3% in the US4, and although UK inflation is currently a relatively modest 2.1%5, the Bank of England expects it to rise to 4% by the end of the year.
Supply chain disruption
A key factor behind these trends has been product and labour shortages resulting from the pandemic, with Brexit also compounding problems in the UK. The auto industry provides a good example of the dynamics at play. As economies have reopened, demand for vehicles has jumped. However, a dearth of computer chips (not least as production was diverted to consumer electronics) has hampered production of autos on both sides of the Atlantic, with output down 38% y/y and 34% y/y in the UK and US respectively in July7,8. In turn, a shortage of new cars has boosted prices for used vehicles, which at their peak were up 45% y/y in the US9, making a large contribution to the acceleration in inflation since the start of the year.
However, supply chain issues go beyond computer chips and autos. The periodic closure of ports and manufacturing facilities in Asia due to outbreaks of the Delta variant, along with the ongoing shortage of shipping containers is hampering the supply and boosting the prices of a range of manufactured goods and raw materials. Congestion at ports, both in Asia and the West, has risen sharply. And shipping costs, as measured by the Drewry world container index have risen more than five-fold to around US$10,000 since the beginning of 202010.
Problems recruiting workers domestically are also holding back activity and putting upward pressure on wages and prices. Labour shortages in the UK, most notably in the freight, construction and hospitality sectors, have been well documented in the press. However, with a range of factors curbing the supply of workers (including fear of the virus, childcare issues, restrictions on labour mobility, income support measures, career-changing and increased numbers taking early retirement) the problem has been prevalent in many advanced economies.
In the US, a record number of small businesses cannot fill job vacancies despite the fact that the unemployment rate of 5.2% is currently higher than pre-pandemic levels11. Indeed, figures for August showing the pace of employment growth slowing to a weaker-than-consensus 235,000 at the same time as wages rose more quickly than expected have played a key role in fuelling market chatter regarding stagflation12.
A key question going forward is how long these stagflationary tendencies will continue. Some covid-related supply bottlenecks and price pressures associated with reopening economies should prove temporary. Advocates of the transitory inflation view cite the example of lumber in the US, where the wholesale price has fallen back after spiking during the spring as supply has increased13. Used car prices are also starting to ease back from their highs14. Moreover, as children go back to school and emergency income support measures (furlough schemes in Europe, enhanced unemployment benefits in the US) are wound down, the supply of workers might improve somewhat, boosting employment and reducing upward pressure on wage growth.
Much will depend on how covid, and the Delta variant in particular, progresses. In economies with high levels of vaccination/immunity, reduced fear of the virus holds out the prospect of more individuals rejoining the workforce, fewer disruptions to activity, and consumer demand shifting further from manufactured goods to services (where there is more slack).
However, with experts becoming increasingly sceptical regarding the possibility of herd immunity, the prospects are not particularly encouraging on this front15. To be sure, the return to widespread, full-scale lockdowns should hopefully be avoided. However, the increased transmissibility of the Delta variant risks repeated factory/port closures due to recurring covid outbreaks (especially in countries with low vaccination rates or those such as China that operate a ‘zero covid’ policy), while also hindering a return to pre-pandemic consumption and employment patterns.
This, along with other factors, suggests that ‘shortages’ of goods and labour could continue for a while. The Confederation of British Industry (CBI) has forecast that problems with labour supply in certain industries could last for two years and has called on the government to relax post-Brexit immigration rules (a request that the government has so far refused). Training workers for the skills that the economy requires clearly takes time, as will the investment to expand capacity in sectors that are currently struggling to meet demand (e.g., shipping, semiconductors etc.).
The stagflationary tone of recent data poses a dilemma for central bankers. Slowing growth suggests the need for continued monetary stimulus, while elevated inflation and a tight labour market would ordinarily argue for less accommodative policy. The consensus amongst central bankers in the US and Europe is that the recent pick-up in inflation is transitory and therefore does not require a hasty tightening of policy. To a large extent, this view is likely to be borne out; inflation in the US is already showing signs of peaking, and this year’s big increase in energy costs and used car prices are unlikely to be repeated. As a result, base effects will serve to pull annual inflation rates down next year.
However, there is a risk that policymakers are overestimating the degree of slack in the economy, with the result that broader and more persistent price pressures develop and prevent inflation falling back as fast as they expect. This is a particularly pertinent issue in the US, where, given the Federal Reserve’s focus on reducing unemployment, last month’s disappointing jobs data has raised speculation that the timing of any QE tapering (i.e., reducing the amount of bonds purchased under the quantitative easing programme) will be pushed back17.
While stagflation-like data increases uncertainty regarding monetary policy, it also raises questions about the outlook for corporate profits. So far, supply chain disruption, along with rising wage and input costs have made little impact on profit margins. On the contrary, according to Factset the net profit margin for the S&P500 companies rose to 13% during the second quarter, the highest level since 200818. This has come about as companies have been able to offset some cost increases by improving productivity, while also raising prices. However, it is unclear how much longer this can continue, as companies are forced to increase pay and conditions to attract workers.
Moreover, it is interesting to note that while economists have been revising down their third quarter GDP growth forecasts recently 19, equity analysts have been revising up their corporate earnings expectations 20. Against this backdrop, it would not be surprising if we see an uptick in profit warnings during the coming weeks. Although a return to the dark days of 1970s-style stagflation is unlikely, the current economic environment will still present its own set of challenges.
14th September 2021