Will slow growth and inflation lead to stagflation? Economist Greg Daco speaks to Radio Davos

The global economy has been having a rocky ride. There was the pandemic, there was the supply chain squeeze coming out of the pandemic, and then Russia’s invasion of Ukraine. Many developed countries now have inflation levels unseen for a generation or two and economic growth is down.

On this episode of Radio Davos, Gregory Daco, Chief Economist at EY-Parthenon, Ernst & Young's global strategy consulting arm spoke to the World Economic Forum's Abhinav Chugh about economic slow-down, inflation, global debt ratios, and the thing all policymakers want to avoid: stagflation.

Abhinav Chugh, World Economic Forum: From your perspective, which economic issue is currently not receiving enough attention?

Gregory Daco, Chief Economist at EY-Parthenon: I think the issue that's receiving the most attention is inflation, and rightly so because it's a key concern for global economic activity and and just for global activity in in general.

I think the one issue that is perhaps underestimated in terms of potential risks to global economic activity is that of food insecurity. We've seen that in the wake of the war in Ukraine we've had some significant disruptions to food flows around the world and we continue to have them. The combination of sanctions, the combination of trade tensions, as well as some bad weather which have influenced crops are affecting food prices and we've seen food prices reach record highs in recent months.

And the reason why I think this is an underestimated issue is that it's not just an issue for today, it's an issue for tomorrow as well because we are in this environment where we could see lingering disruptions to food supplies and we know that those can have political ramifications in particular in countries in the Middle East and Northern Africa where in the past we've seen bread riots when there are disruptions to food prices and food supply. So that is, in my opinion, one key issue that is perhaps under-discusssed but should be an area of focus and attention over the coming months.

Abhinav Chugh: And there are various versions of austerity coming forward by governments around the world - from watering deficits to negative fiscal impulses. What could this lead to given rising inflationary pressures?

Gregory Daco: I think the number one consequence of less significant positive fiscal impulse around the world is that you have less demand growth.

One of the key facets of the COVID recovery was that governments around the world put in place massive stimulus programmes to try to stave off the initial impact from the COVID crisis where you had a sudden stop and demand and sudden stop in supply and the massive influx of government stimulus allowed for a very rapid recovery in economies throughout the world. The US being a prime example where the passage of over $5.5 of fiscal stimulus measures, more than 10% of GDP, allowed the US economy to really recover very rapidly from what was one of the most significant post-World War Two economic shocks. So that was the key impulse. Now we're seeing much less fiscal impulse actually in most advanced economies. You're actually seeing a drag from the fiscal side of the picture which if combined with an environment where you have higher inflation will essentially erode demand growth erode, growth overall, and weigh on economic activity now.

There are some indications that that's not the only thing that's happening around the world. There are instances where we're actually seeing some desires by governments to actually increase or expand fiscal measures. We've seen, particularly in Europe, this desire to increase energy independence and to focus on energy investments over the next few years. That may be another source of fiscal impulse, but it is a fairly minimal source that will likely play out over a longer period of time - very different from the types of investments that we saw in the post-recovery period.

Abhinav Chugh: Real wages are also under pressure. What could a wage-price spiral lead to? Are we at a risk of heading towards a situation where there's stagflation?

Gregory Daco: The idea of a wage price spiral goes back to the late 1960s and early 1970s, where we had an environment in most countries around the world where you had elevated inflation and as a result elevated wage growth and the combination of the two were feeding off of each other, the idea being that in a higher inflation environment employees would essentially have more bargaining power and they would ask for higher wages. Companies facing those requests would then have to essentially take on those additional costs but also pass them on and so they would increase their prices and so you end up with this environment where you're essentially in a higher inflation regime where inflation is no longer trending at a modest 2% clip but it's at a 4,5,6,7% steady state which is very different in terms of the economic consequences because what tends to happen in a high inflation regime is that you have an erosion of growth.

Consumers spend less because in real terms when you adjust wage growth for inflation, where you essentially adjust wage growth for the cost of living, then that is actually declining and so what happens oftentimes is that consumers are less able to spend, businesses are less able to invest and hire, and so there is a natural cutback in economic activity. Leads to slower growth, slower productivity growth and depressed living standards. And that type of environment is something that most authorities around the world, whether it's governments or central banks, really want to avoid. They want to avoid this type of so-called stagflationary environment where you have stagnation from an economic perspective and still elevated inflation on both the consumer price front and the wage growth front. That is definitely something that authorities throughout the world want to avoid.

Abhinav Chugh: What measures do economies undertake to avoid these kind of wage-price spirals and stagflation? What have they done in the past and what do you see a lot of governments and central banks doing right now to handle the situation?

Gregory Daco: I think the key is really understanding what drives these wage-price spirals. Right now I don't think we're in that type of environment, certainly not at a global level. There might be some countries that are inching closer so closer to that type of environment where you do have elevated inflation and elevated wage growth, the US, for instance, might be an example where there is a risk of moving into that realm. We're not there yet. We have CPI [consumer price index] inflation that's around a 40-year high, we have wage growth that's slightly above 5%, also near a 40-year high, but we have not seen this acceleration of this phenomenon. We've not seen inflation continue to accelerate. If anything there are signs that it may be plateauing. And wage growth is also not accelerating. We're seeing wage growth stabilize in that upper 5% range, which is certainly concerning from a long-term historical perspective, but we're not seeing that move further up.

If you look at Europe, in the euro zone in general we have record high inflation multi-decade high inflation, but wage growth is not excessively hot and therefore that's also less of a concern.

The key concern for policymakers is really that we end up moving towards that type of environment and in order to avoid that they really want to make sure that they anchor inflation expectations at a moderate to low level. Essentially avoid a situation where people expect inflation to continue to be rampant, expect to see higher wage growth, and then we move towards that higher inflation regime and the risks of stagflation increase.

So what central banks are doing throughout the world is essentially tightening monetary policy quite aggressively. We are in the midst of an unprecedented global synchronized policy tightening cycle, and that will weigh on inflation dynamics. It will first weigh on demand. We've already started to see the initial signs of weaker demand growth in interest rate sensitive sectors. It's also weighing on financial conditions which will weigh on demand. And eventually the idea or the thought process from central bankers is that by weakening demand we'll see essentially a rebalancing of demand and supply which will put downward pressure on inflation and avoid economies throughout the world moving from a current moderate inflation regime towards a high inflation regime which typically tends to take much more drastic actions to exit from, these these higher inflation regimes.

Abhinav Chugh: And given that you mentioned that wages are not really growing across much of the advanced economies, could you share some insights on what we mean by perhaps wage restraint and could that be a potential solution here?

Gregory Daco: Well, if you look at wage growth relative to inflation in most economies throughout the world, what you have is essentially negative inflation adjusted wage growth. So if you take wage growth, nominal wage growth, and adjust it for the cost of living, we’re actually living through a period where you have in most countries a contraction in so-called real wages so inflation adjusted wages are falling.

There have been some discussions in some countries around the world, most notably the UK, where there's been discussion of so-called wage restraint, the idea being that there is an agreement between employees and employers and oftentimes unions not to request higher wages. And by doing so essentially you curb or reduce the pressure on businesses on companies to then pass on those higher wage bills, higher labour costs, to the final consumer.

Now that is not necessarily the optimal way out of this situation of sticky and persistent high inflation. I think we often forget that there are easier, perhaps not easier, but ways that may increase standards of living that can help alleviate some of the pressures, especially on the labour front. And one of those is increasing productivity. That can come through an increase in the labour supply so increasing labour force participation which we know is still constrained relative to the pre-covid period. So that is one way to alleviate some of the wage pressures because if you have greater supply that tends to put downward pressure on wage growth. And the other is productivity terms of processes, ensuring that you have the most efficient processes in place to allow some of the higher unit labour cost to be offset by these productivity gains. Those are important strategies that businesses have to consider and that a lot of businesses are considering in the current environment.

Abhinav Chugh: And if wage restraint is not being looked at as a solution, are there any consequences in terms of expected wage inflation in the coming months? Could it overtake price inflation?

Gregory Daco: Well, there's certainly a potential for the dynamic between inflation and wage growth to reverse, if not on a structural basis, on a shorter term basis. We are going to be, over the next year or so, in an environment where global economic activity is going to slow down materially. Global growth is likely to slow from close to 6% last year to around 3% and perhaps slightly below that this year and then and then next. In the US we're expecting growth also to cool from just above 5.5% to around 2% this year and and probably less than 1% next year. So we are in for a fairly material slowdown in terms of economic activity around the world. That will put downward pressure on inflationary dynamics.

We know there's some stickiness to price inflation. We're seeing in some countries the advent of higher housing prices, higher rent prices, which is leading to some stickiness in prices. We're also seeing some sectors that are in higher demand right now like service sector, travel, leisure, hospitality in general, which are also seeing upward pressures, but I would expect that as we see slower demand globally, in particular for goods, we're going to see some pretty significant disinflationary forces weigh down on the overall inflation outlook. Now, that may take time to be filtered through to wage growth. But if we, at the same time as we see these disinflationary forces, these disinflationary pressures, in some sectors of the economy, we see some restraint in terms of hiring and perhaps a cooler labour market throughout the world, that might also put downward pressure on wage growth.

So I wouldn't expect necessarily to see an environment where for a prolonged period of time we see wage growth higher than inflation, but it's certainly a possibility. The thing is that it wouldn't be a possibility on the upside i.e. it wouldn't be a situation where wage growth accelerates much faster than inflation. It would actually be most likely a situation where inflation decelerates faster than wage growth, and so that would be the type of situation we would be in, most likely.

Abhinav Chugh: So global economic activity is bound to reduce and we're going to see growth come down. However, global debt ratios keep rising as well. What could this lead to, especially for the developing world?

Gregory Daco: Yes. As we look around the world, we are in an environment where governments throughout the world passed a lot of fiscal measures to try to stave off the economic impact from the COVID crisis and facilitate a rapid recovery from the COVID crisis.

What that has led to is higher debt levels, and in an environment where economic activity is slowing, the debt ratios across the world are rising, sovereign debt ratios are rising. That in itself is not excessively worrisome.

What is worrisome is the cost of that debt because when you look at the debt servicing ratios throughout the world, they are rising and they're rising for two reasons. Number one, as you said, the levels of debt across a number of markets, both advanced markets and emerging markets, have increased. But in addition to that we have an environment in which interest rates are rising. Interest rates across most advanced economies are rising rapidly, interest rates across emerging markets are also rising.

And so in that type of environment the debt servicing cost is also increasing and one important element to note, in particular for developing economies around the world, is that the rise or the strengthening or the appreciation in the US dollar adds another layer of burden on top of the rising levels of debt and the rising interest rate cost. Because if you have a larger share or a large share of your debt that is in dollars, the appreciation of the US dollar makes that debt that much more expensive.

So for a number of emerging markets, we are in an environment where the cost of servicing debt is increasing. It is increasing at a relatively rapid pace and it could cause some problems in terms of debt sustainability in the coming months and coming years. So we are paying very close attention to debt development. Again, the combination of higher debt levels, higher interest rates and a stronger dollar mean that it costs more to service the debt for a number of developing countries.

Abhinav Chugh: How sustainable do you think the solution of rising interest rates by central banks as a coping mechanism is, because we saw in the US with the Fed raising interest rates to handle the crisis during the COVID pandemic and now we're seeing some of the consequences of that as well... What do you think would be your recommendation for other economies to avoid the situation that the US is encountering right now?

Gregory Daco: It's undeniable that we were in an environment where [...] central banks were a little bit late to react to higher inflation dynamics. Most central banks around the world believed that the bout of inflation would be largely transitory a year ago, and here we are with an environment where there is increasing persistence in terms of inflation dynamics.

So when you look at what central banks around the world are doing, the key element to focus on is essentially avoiding a situation in which inflation expectations are getting out of hand, essentially an environment in which inflation expectations continue to grow and in which you risk moving towards a higher inflation, higher wage regime, wage growth regime, where you are essentially edging closer and closer to a stagflationary environment.

One important consideration though for a lot of central banks around the world is the ramifications from a foreign exchange perspective of having the Fed tightening monetary policy more rapidly than others. If you look at the recent appreciation of the US dollar, it's essentially a reflection of the fact that the Fed is moving aggressively to tighten monetary policy. That has the effect on other economies of their currencies depreciating if their central banks are not raising rates as rapidly or tightening monetary policy as rapidly as the Fed. And a depreciating currency for these markets means that there's even a greater pass-through of inflationary dynamics because import prices are rising, and for small open economies like a number of emerging markets that can add another layer of complication.

So I think one of the encouraging developments that we've seen in emerging markets in recent months and during the COVID period is rather proactive monetary policy, with central banks tightening monitoring policy in advance of the Fed and actually preventing some of these devaluating forces that are occurring right now with the Fed tightening monetary policy aggressively.

Abhinav Chugh: You mentioned import costs rising as well. How much of a factor have supply chain disruptions been towards rising inflationary pressures as well? Has has the war in Ukraine been a factor in contributing towards it?

Gregory Daco: If you look at the inflation numbers today they would be notably lower had there not been the war in Ukraine. We are in a situation where we've seen a significant ramp up in oil prices, in gas prices, natural gas prices, in agricultural commodities, in fertilizers, in a number of raw materials, that are emanating directly or indirectly from the war in Ukraine. So it's undeniable that in today's environment some of the inflationary pressures that we're seeing are a reflection of what is happening in Eastern Europe with the war in Ukraine.

Unfortunately this is something that we have to deal with. It's not like we can go back in time and readjust that situation. That is a factor that is going to be with us for the foreseeable future. We are seeing sanctions being increased vis-a-vis Russia. We are seeing lingering disruptions in terms of food supplies in terms of commodities. And these are not going to disappear overnight. We are seeing the European Union move away from energy dependence from Russia. We are seeing crops being disrupted across Ukraine.

Those will have ramifications, not just today but in the coming months and coming years. And so, as a result of that, we're seeing these disruptions reverberate throughout the world and lead to higher energy prices. The natural gas price in the US for instance is a good example, where they've tripled, nearly quadrupled over the past few months as a result of an increased desire to export US natural gas to Europe to replace some of the inflows from Russia. But capacity on the US front in terms of export capacity is limited, and so as a result you're seeing domestic price pressures increase. That's just one example of how a disruption on one side of the world can affect prices on the other, even if the markets are, or were presumed to be largely separate.

So in this globally integrated environment we are going to continue to see ramifications and consequences from the war in Ukraine and from various other supply chain disruptions including the the zero-COVID policy in China which led to renewed supply chain tensions across Asia and further exacerbated price pressures around the world.

Abhinav Chugh: You laid out how there's a decoupling underway and that these disruptions are not bound to go away in the coming years. Despite that, do you foresee a market correction happening in the next six months or a year? Do you find that supply chains will reorient themselves with production centers shifting elsewhere? What does the scenario look like for the coming year?

Gregory Daco: I think we can certainly see and and we will likely see a significant and material slowdown in economic activity throughout the world. But that type of disruption to economic activity will largely come from the demand side. So we're going to see lower demand growth in most economies around the world. We may see a contraction in demand overall in some economies around the world.

Now, to some extent that may help rebalance some of the imbalances that we're observing today in terms of demand and labour. We know that supply chain constraints have been in place for the better part of of the last year and a half, 18 months, and those may be eased by, not just supply increasing, but demand cooling, because we know that one of the key factors that was behind the ever increasing supply chain constraints was the fact that demand was relatively hot including in the US where there was strong demand for goods, strong demand now for services, which put upward pressure and significant constraints on supply chains that were already quite strained at the time.

So in this environment where you see cooling demand where the odds of a recession in the US are relatively elevated before the end of the year, where the odds of a material slowdown in Europe are also elevated, this recessionary environment, this environment of a material global growth slowdown, will put downward pressure on supply chain constraints and help ease some of the the strains that we're seeing.

Unfortunately, it's not the type of improvement in the situation, improvement in the imbalance, that we would want to see. Ideally what we would want to see is supply coming up to demand rather than demand coming down to supply, so that is perhaps an unfortunate consequence of an environment where this imbalance has led to higher inflationary pressures where central banks around the world are proceeding with a synchronized tightening cycle putting upward pressure on interest rates leading to tighter financial conditions and constraining business activity in this high inflation environment where consumers are going to be much more careful with their purchases, businesses are going to be much more careful with their investments and with their hiring plans, and where, as a result, you're going to see a slow down a cooling of economic activity globally.

Abhinav Chugh: To close off, what kind of trends would you be monitoring over the coming months? What factors are you most interested in?

Gregory Daco: I think the number one element to focus on is private sector activity and intentions of activity, because that will be really a key guide as to whether the global economy navigates this period of uncertainty with relative ease or whether we end up in an environment that is recessionary, where we end up in an environment where there is an outright contraction in economic activity.

And what I mean by that is essentially paying very close attention to, not just what consumers are saying, but really what they're doing. Are consumers still buying? And if so, what are they buying and how are they buying? Are businesses still hiring? And if so, to what extent, with what horizon are they looking at? And also what are they investing in? Are we still seeing signs that private sector businesses are investing in the future, are aiming to increase productivity, and are aiming to essentially ensure a world where they've built up resilience, resilience to potential downward shocks in terms of economic activity, in terms of the health situation, in terms of logistical disruptions? And if we have this type of environment then I think we can stave off a recessionary environment, we can avoid certainly a deep recession.

And I think that's, encouragingly, one of the directions where we're seeing businesses build out their investment efforts, it's in ensuring that they are resilient to the next potential downturn or to a period of prolonged uncertainty. And that is very encouraging because, if that is the direction in which businesses are heading into, that can not only ensure a stronger outlook in terms of economic activity, but it can also ensure that we have stronger productivity growth, higher living standards, and higher long-term potential growth, and that is really key in terms of global economic activity.

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