what is it and how to deal with it

Almost a year ago we announced Storm clouds about inflation.

Unfortunately, today, the storm of rising prices, started by a combination of a shock in the prices of energy and raw materials and a vibrant demand in the months after the pandemic, must be added the increasingly pessimistic growth forecasts made by the main international organizations for the world economy and, particularly, for the european

If a slowdown in the economy is added to inflation, if not a drop in growth, we are facing a scenario of stagflation or inflation with stagnation.

The dilemma

Stagflation is not a new phenomenon. Western economies experienced it in the energy crises of the 1970s, stemming from the rise in oil prices.

This situation poses a major dilemma for the authorities that manage economic policies, both monetary (central banks) and fiscal and income policies (governments).

The dilemma lies in the fact that, despite the fact that the causes of inflation lie in the increase in costs (energy and raw materials in the first round), the instruments available to curb prices in the short term only attack demand . That is, they serve to curb aggregate spending in the economy. This brake is achieved by raising interest rates, draining spending from the economy with a fiscal policy or through an income pact that distributes the losses caused by inflation among employees, companies and pensioners. Very difficult thing.

the right measure

When we are in a situation of stagflation, the first dilemma lies in how to articulate contractionary measures –basically raising interest rates– without going overboard. That is, without affecting growth too much, without inducing a recession. And this is very complex because, moreover, the individual room for maneuver of the central banks is scarce and this is reflected in a synchronized rate hike: first the Federal Reserve and then the European Central Bank.

International capital movements do not allow for many differences in this area, if we do not want to see how the currencies of the economies that lose investments depreciate sharply because rates begin to rise more in other areas, as is happening with the euro against the dollar. This movement is reflected in a depreciation of the currency (euro), aggravating the inflationary problems, since the depreciation makes imports more expensive, especially energy ones (which are paid in dollars).

But what the rise in rates causes in the internal demand of the economies is a rise in consumption and a brake on investment, the two most important items to explain economic growth. Thus, raising rates without going overboard so as not to cause a recession is quite a challenge.

The challenge

The challenge of raising rates right on it is aggravated when the policies that are to complement the monetary ones either do not exist (the income pact) or are of the opposite sign, since they contribute to increasing demand, the fuel that continues to fuel the flame of inflation.

Many governments are carrying out actions that try to compensate for the loss of purchasing power caused by inflation: they articulate aid to the population as a whole, subsidize goods that do not reduce their consumption sufficiently –such as fuels– or agree on considerable income increases in groups, especially sensitive for electoral arithmetic –read pensions–.

Governments face their own dilemma: to recognize the loss caused by the shock inflationary and try to accommodate this loss between groups, or apply a policy of increased spending to mitigate the loss, which can increase the existing imbalances.

This scenario of two demand policies –fiscal and monetary–, which, far from being coordinated, enter into contradiction, is increasingly likely. And it justifies that interest rates either continue to rise (to compensate for spending caused by fiscal expansion), or remain relatively high, which would especially affect the most indebted economies.

Rubén Garrido-Yserte, Director of the University Institute of Economic and Social Analysis, University of Alcala

This article was originally published on The Conversation. Read the original.