Joachim Nagel is the president of the Deutsche Bundesbank.
Flashy wallpaper, corduroy flares, long sideburns, disco and punk. The 1970s was a loud, “in your face” decade. And for many, that decade still holds appeal. Revivals come around again and again, whether in fashion or music.
Economically speaking, however, the 1970s was a difficult decade, plagued by two oil crises, currency turmoil and rising unemployment. The combination of high inflation and a stagnating economy was so unusual that it even brought forth a new portmanteau: stagflation.
Thus, the present situation, with its high rates of inflation and considerable risks to economic activity, is awakening unpleasant memories. Is it now the economy’s turn to experience a 1970s revival?
Parallels to that effect are, indeed, emerging.
Stagflation is generally triggered by unexpected events, or “shocks,” that reduce aggregate supply and push up prices. Both oil crises in 1973 and 1979-80 were examples of supply shocks, which severely impaired economic growth, while pushing up inflation. In the United States, the rate of inflation rose to almost 15 percent in March 1980.
Supply disruptions are also behind current high inflation. But while the strong recovery from the pandemic-induced recession, in conjunction with expansionary macro policies, played an important role in this, it isn’t the only driving force here. Supply chains have been disrupted; commodity and transportation prices have shot up.
Russia’s war against Ukraine has triggered further shortages and price increases — above all for energy, but also for food. And there could be worse to come if the conflict escalates, as a downside scenario recently calculated by Eurosystem staff illustrates.
The labor market in some advanced economies seems to bear similarities to the environment in which stagflation emerged in the first place: When labor is in short supply, employees are in a better position to push through high wage demands to offset the steep price increases. And where wages go up substantially, there’s also a risk that prices will jump further. This depends on the behavior of firms. For them, it’s easier to pass on the burden of higher costs by raising prices if demand is strong and other firms are increasing their prices as well.
But there are major differences between now and the 1970s. For one, the energy intensity of advanced economies has more than halved since 1980. And though it may not seem so at present, increases in energy prices today are generally likely to cause less damage to the economy. Moreover, wage-price spirals no longer emerge as readily, not least since the bargaining power of unions is much lower today. And there have barely been any signs so far that such a spiral could emerge in the euro area.
In this context, the role of inflation expectations and, thus, of monetary policy is crucial.
In fact, the most important difference between the 1970s and today is that central banks’ independence is more respected, and a greater importance is attached to the objective of maintaining price stability. Moreover, central banks have gained credibility in their commitment to preserving it.
Faced with major political pressure to fight unemployment in the U.S. in the 1970s, the Federal Reserve’s response was too little, too late. Interest rates ended up rising faster and higher than they would have had to if policy actions had been taken in good time. The Fed didn’t manage to bring inflation and inflation expectations under control until it implemented a highly restrictive monetary policy in the early 1980s, which came at the cost of a severe recession.
The Eurosystem’s primary objective is to safeguard price stability. Its independence, its track record of low inflation and its clear monetary policy strategy distinguish the current situation markedly from that of the Fed back then. As a result, most experts nowadays expect inflation rates to return to the Eurosystem’s target over the medium term, and this anchoring of inflation expectations is a landmark achievement.
However, history has shown that inflation expectations can become unanchored if central banks are too slow to tackle inflation, and we must do things better this time round.
While inflation expectations for this and next year have risen strongly of late, longer-term inflation expectations are still close to our target of 2 percent. We need to make sure that things stay this way.
With the decisions taken on June 9, the Governing Council of the European Central Bank has demonstrated its determination to bring inflation over the medium term back to target. We need to act resolutely. Thus, the policy rate hikes in July and September can only be the beginning. As things stand, a timely return to a neutral level, if not beyond, is required.
There’s no telling whether flashy wallpaper, flares or sideburns will make a comeback in the future. However, what we can and certainly should do is make smart policy decisions to prevent “stagflation redux.”
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