SINCE THE FIGHTING STARTED in Ukraine, US bond yields have fallen and equities are down about 2% globally. of 2022. Simultaneously, inflation is raging and expected to be pushed higher by soaring global energy and commodity prices due to war, sanctions and the threat of supply disruptions. It’s no surprise that the word “stagflation” is buzzing as the world grapples with the possibility of both slower economic growth and higher inflation.

SUPPLY IS USUALLY THE GUILTY, NOT DEMAND
The combination of higher prices and lower production usually results from an adverse supply shock. That’s what happened in the 1970s when the twin oil embargoes in 1973 and again in 1979 stunted growth and drove up prices. Such a situation could reoccur if sanctions or acts of war disrupt the flow of Russian or Ukrainian oil, gas, wheat, corn and other raw materials around the world.

Higher prices would reinforce a demand-driven price and wage spike already underway before the invasion. Accelerating inflation followed an unprecedented peacetime fiscal expansion in 2020-21 that coincided with sluggish production, distribution and labor supply responses due to pandemic disruptions . Inflation was also exacerbated by a shift in consumer spending from services to goods that caught producers off guard.

US INFLATION IS RISING, BUT NOT LIKELY TRAINING FOR STAGFLATION
There are two reasons why stagflation in the United States is unlikely. The first is that adverse supply shocks are only part of the reason inflation is now high. Excess demand is a bigger part of the story, and demand is already slowing. In doing so, price and wage pressures are likely to ease.

The second reason is that an adverse supply shock alone cannot create permanently higher inflation. Either it must trigger a wage-price spiral or it must induce central banks to ease and over-stimulate demand.

Readers may be puzzled: Aren’t prices and wages rising already? Yes they are. But the key is to understand the difference between a one-time “shock” of demand exceeding supply – something the United States and much of the global economy has recently experienced – and an ongoing price spiral, which cannot result only from a continued persistent increase in demand exceeding supply. The latter leads to continuous inflation. The first has a temporary period of price increases which, on its own, will cap.

So why is demand unlikely to exceed supply? One of the main reasons is the collapse of purchasing power. Inflation-adjusted wage growth is falling rapidly, the worst period of falling real wages in a quarter century. The February US jobs report provided further evidence: average hourly wages are not keeping up with rising prices.

Some observers might counter that workers will step up their demands for higher wages. It could happen, but a return to 1970s-style wage-price spirals seems unlikely. Unionization rates have plunged over the past half-century, eroding the collective bargaining power of workers. Automatic cost-of-living adjustments are a distant memory. Moreover, surveys and market indicators show that long-term inflation expectations are not compatible with a generalized expectation of a sustained rise in inflation. If households and investors thought a wage-price spiral was likely, long-term inflation expectations would surely rise.

Another reason inflation expectations haven’t budged much is that the 2021 spending boom has peaked. Household savings have fallen back to pre-pandemic levels, suggesting that “pent-up” demand is receding. Meanwhile, last year’s COVID-19 relief checks, child tax credits and health care spending surges are over. Public spending from last year is not repeated this year. Fiscal stimulus quickly becomes a fiscal drag. In the United States, fiscal policy could reduce gross domestic product growth by at least one percentage point this year.

In short, no precondition for the inflation side of stagflation is likely. It seems unlikely that demand will exceed supply on a recurring basis. And a wage-price spiral seems unlikely.

EUROPE FACING MORE UNCERTAINTIES
In Europe, the situation is different. Unlike the United States, Europe is a major importer of energy, both crude oil and natural gas. Gas storage was already at low levels at the start of this crisis, creating conditions in which higher prices will unambiguously reduce the purchasing power of European households and therefore aggregate demand. Europe’s dependence on Russia and Ukraine for key agricultural products and metals could also impact input costs for businesses in several sectors, further impacting inflationary pressures. For all these reasons, the risks of a slowdown in growth in Europe are significantly higher than in the United States. And, as in the United States, measured inflation is stimulated by one-off supply shocks, mainly due to commodity prices.

SLOWING GROWTH IS THE RISK CHINA IS FOCUSING ON
China has seen slower growth in recent years, accelerated by zero-COVID policies and rising input costs, especially raw material costs, which have not been passed on to the consumer for the past couple of years. years. Domestically, China remains crippled by housing market excesses, many of which stem from past lax borrowing standards and poor investment decisions. At the same time, Chinese leaders have expressed their dissatisfaction with growth that risks falling below the 5% mark. If US growth slows this year and Europe’s recovery stalls, China’s export engine is unlikely to be enough to meet Beijing’s overall growth targets.

FOCUS ON CENTRAL BANKS’ RESPONSES
What does all this mean for monetary policy and interest rates?

Despite slowing growth and rising uncertainty, the Federal Reserve (Fed) remains determined to tighten US monetary policy. Certainly, Russia’s invasion of Ukraine has changed the calculation of how quickly the Fed will act. Fed Chairman Jerome Powell openly declared his preference for a quarter-point hike at this month’s Federal Open Market Committee meeting, quashing any expectation of a larger move. Russia was the cause.

Still, the Fed remains confident that the fallout from the war will be modest. This is partly because the United States is self-sufficient in energy. While higher oil prices will likely weaken US growth via lower real wages in 2022, the impact is likely to be less than during the oil embargoes of the 1970s, when the US was a major energy importer and that energy was a bigger part of the economy.

The European Central Bank (ECB) faces a bigger challenge on what to do. Its mandate is unique: to keep inflation low. But he cannot reasonably ignore that the war and soaring commodity prices jeopardize any economic recovery. European countries can increase defense spending, but this impact will not be felt for quarters or even years. As a result, the ECB will be reluctant to follow the Fed’s rate hike cycle, even if headline inflation remains above the ECB’s target.

But perhaps the most interesting central bank to watch this year will be the People’s Bank of China (PBOC). The fallout from the Russian invasion, coupled with the end of Western fiscal stimulus, is pushing the PBOC to reverse a global tightening trend and ease monetary policy in 2022. Global growth, which over the past two years has been held back by Western fiscal stimulus, could be moving east again as China struggles to support its economy.

Ultimately, investors must avoid being drawn into discussions of stagflation. It’s a more common term in the media than economics, and for good reason. Instead, savvy investors will focus on how central banks are responding to the changing fortunes of the global economy and the jolt brought on by war. Their actions will drive global bond markets and therefore all portfolios.

*Source: MSCI. From February 24, 2022 to March 4, 2022.

Stephen Dover is Chief Market Strategist and Director of the Franklin Templeton Investment Institute.