Bank for International Settlements Warns of Potential for 1970’s Style Stagflation

The Switzerland-based “bank for central banks” has warned of the possibility of a 1970’s style episode of stagflation, with consumer prices and unemployment both rising in tandem.  

In its annual report released at the end of July, the Bank for International Settlements (BIS) said that “a modest slowdown may not be enough” to contain the inflation that is wracking the advanced economies of North America, the Eurozone and Australasia.  

BIS even went so far as to compare the world’s current round of post-Covid inflationary pressure to the “stagflation” of the 1970’s, that eventually forced the Fed to raise interest rates into double digit territory under the tenure of Fed Governor Paul Volcker.  

“Lowering inflation could have significant output costs, as after the ‘Great Inflation of the 1970’s,” the BIS report said. “Even then, inflation may not fall quickly, given the intensity of recent price pressures.” 

“In a worst-case scenario, the global economy could be set for a period of stagflation, involving both low growth, if not an outright recession, and high inflation.”  

The term “stagflation” refers to the phenomenon of prices and unemployment both increasing simultaneously – a disastrous outcome for both economic policymakers as well as ordinary citizens.  

The phenomenon of stagflation runs contrary to the Phillips Curve that guides monetary policy by central banks, and dictates that prices and unemployment normally move inversely.  

The modern era’s first episode of stagflation took place in the 1970’s , and prompted Federal Reserve Governor Paul Volcker to raise the federal funds rate to an average of 11.2% in 1979, before it eventually lifting it to over 20% 1981.  

While Volcker’s decision caused a US recession from 1980 to 1982 and drove the unemployment rate to over 10%, it did manage to throttle the rampant inflation that wracked the US economy during the 1970’s.  

The bitter pill of Volcker’s sharp interest rate hikes helped to pave way the way for the prosperity seen during the Reagan and Clinton administrations towards the end of the 20th century.  

As a data-driven institution intended to represent the interests of the world’s central banks, BIS is anything but prone to hyperbole. For this reason, its willingness to moot the possibility of another staglationary episode should ring alarm bells for investors. 

This is especially the case given that economic conditions differ markedly from those at the end of the 1970’s, when Volcker first embarked upon his breakneck drive to push interest rates north of 20%.  

These conditions include the fact that the target fed funds range – the short-term interest rate targeted by the Federal Reserve, currently sits at just 2.25 – 2.50%. In 1978, the year prior to Volcker’s appointment to the position of Fed governor, the federal funds rate already stood at 10.0% in December.  

Inflation was also far lower in 1978, sitting at 7.6%, as compared to the four year high of 9.1% as of June 2022. During Volcker’s tenure inflation would eventually peak at 11.3% in 1979, before declining in the opening years of the 1980’s on the back of his rate hikes.  

Leading observers such as former PIMCO CEO Mohamed El-Erian contend, however, that US inflation is on track to continue rising in 2022 on the back of constricted energy supplies. 

BIS further points out that the US economy is currently subject to “elevated financial vulnerabilities” that are “historically unprecedented.” Chief amongst them are high levels of debt, alongside an overheated real estate market.  

These issues could make the impacts of further rate hikes from the Fed far more painful for the US economy than the even sharper increases implemented by Volcker at the turn of the 1980’s.