Is a major recession unavoidable? Three economists give their views

Brigitte Granville, Professor of International Economics and Economic Policy, Queen Mary University of London

Stagflation is upon us, so a natural focus for any where next? discussion must be whether we are on course for an episode as bad as the 1970s or even worse. My answer would be that recession is likely, but the 1970s experience of high inflation persisting despite repeated recessions should be avoidable. That said, even a relatively milder dose of stagflation will be painful for living standards.

The mildest way out of the present situation would be inflation promptly curing itself: by making people poorer in real terms so they can’t afford to buy so much. In this scenario, inflation would ease and central banks could help with the downturn in the economy by reversing their present interest-rate hikes.

There are several obstacles to such a fast turnaround, however: the context of the post-COVID recovery and the labour market.

The main inflationary impulse has come from two factors on the global supply side. First, supply chains have struggled to cope with demand collapsing and resurging during and after COVID, made worse by China’s zero-COVID policy. Second, energy and other natural resource supplies have been constrained by Russia’s war in Ukraine and the west’s sanctions.

The inflationary effects of these issues are being prolonged by pent-up demand from western firms and consumers due to COVID stimulus packages in the UK and especially the US, as well as unspent income accumulated during lockdowns. In the UK, for example, household deposit balances were still well above pre-COVID levels as recently as April.

It doesn’t help that the financial markets have been driven to such heights by loose monetary policy. Although the bubbles have been popping recently, valuations will have to fall some way further before people feel poorer and less willing to go out and buy things.

Turning to the second obstacle to a rapid reversal of the inflation surge, namely the labour market, the main problem again comes from the supply side. Labour demand from firms has normalised post-COVID, but there are too few workers. This is partly to do with more people over 50 choosing not to go back to work, but the UK has the additional problem of Brexit interrupting the flow of good quality labour from central and eastern Europe.

With too few workers, companies are being forced to pay people more UK wages are rising at about 4% a year and to pass on the cost to customers in the prices of goods and services. Alert to the threat of a 1970s-style wage-price spiral, the Bank of England has been raising interest rates.

But leading indicators suggest that the wage-price spiral threat is not that serious. The closely watched Purchasing Managers’ Index, which gauges UK companies’ optimism about the economy, shows that those in services are becoming gloomier about the coming months.

You don’t keep increasing prices if you think people are going to stop buying. And while we may have seen faint echoes of 1970s-style labour militancy in transport, for instance, pessimistic companies are generally more likely to cut hiring plans and output rather than give way to hefty wage demands if not shut up shop altogether.

It seems to me that this will be more decisive in determining the course of inflation since it is a long-term structural issue, whereas the post-COVID issues should eventually straighten out. So overall, I expect that the UK economy’s present stagnation, quite likely dipping into mild recession, will bring inflation back down towards the 2% target. In the US, where underlying demand and credit is stronger, sharper interest hikes may be needed to achieve the same goal.

The main danger in my view is central banks becoming too dogmatic about their 2% inflation targets. In my book Remembering Inflation, I reviewed convincing research findings that inflation levels up to 5% cause little or no long-term damage to growth especially if the inflation rate is steady rather than volatile. So once inflation eases a little, central banks should stop hiking interest rates to avoid doing more harm than good.