Interview
How Policymakers are Navigating Stagflation Risk
- Core Economic Risk: The episode identifies a heightened risk of stagflation (stagnant growth combined with high inflation), driven by two primary growth risks against a backdrop of multi-decade high inflation.
- U.S. Policy Risks:
- The Federal Reserve faces the risk of a policy mistake by not pivoting earlier, having remained focused on temporary inflation drivers until late spring/summer.
- Current conditions show inflation well above 2% (via PCE and CPI) with unemployment below 4%, suggesting real interest rates should be positive and slightly above neutral to meet a 2% target.
- Eric Rosengren (former Fed Boston President) argues the Fed is "behind the curve" and has significant room to tighten further to align with historical norms.
- Monetary Tooling Debate:
- Rosengren suggests the Fed may need to rely more on balance sheet recalibration than federal funds rate hikes to effectively address supply-demand imbalances.
- Raising the federal funds rate primarily reduces demand for long-term financing (housing, autos) but does not increase supply; shrinking the balance sheet could steepen the yield curve, encouraging financial intermediaries to lend.
- Rapid short-term rate hikes risk flattening the yield curve, reducing the incentive for financial institutions to lend and potentially rationing credit to borrowers.
- Recession Probability:
- A faster pace of Fed rate hikes increases the probability of a monetary policy-induced recession due to the unpredictability of labor market dynamics and historical analogies.
- The highest risk of overtightening is identified in the second half of the year, contingent on oil prices, Ukraine conflict developments, and potential new COVID variants.
- Goldman Sachs Global Investment Research (Jan Hatzius) notes the risk of a policy-induced recession has risen, with a baseline forecast for a "soft landing" that sees growth slow to ~2% before dipping slightly below, alongside a funds rate peaking near 3% by year-end.
- Growth forecasts for the U.S. are below consensus, implying central banks are delivering contractionary shocks to an economy already at risk of disappointment.
- Euro Area Stagflation Risk:
- Philip Hildebrand (BlackRock) states stagflation risks in Europe have grown sharply due to a "supply shock layered on top of supply shock" (post-COVID restart plus Russia-Ukraine conflict).
- The Euro Area faces a predicted growth hit of 2–3 percentage points, potentially moving the region from a 4% growth consensus to a zone dangerously close to stagflation.
- Specific risks include weaker real incomes, lower consumer/business confidence, and disruptions to essential input supplies, particularly if Russia cuts off gas.
- Monetary Policy Outlook:
- Policymakers (Fed and ECB) feel compelled to continue tightening to prevent the "de-anchoring" of inflation expectations, despite the growth costs.
- Hildebrand predicts a "shallow" normalization cycle where central banks will ultimately have to "live with higher inflation" because killing the economy to lower supply-driven inflation is not a viable trade-off.
- Jan Hatzius expects aggressive Fed tightening to peak in the 3.0% to 3.25% range, which exceeds current market pricing.
- Uncertainty regarding the magnitude of fiscal drag (estimated 1% to 3% impact on growth) and geopolitical fallout complicates policy calibration.
- Forward-Looking Stance:
- The conversation concludes that while the risk of a COVID-induced downturn remains, the risk of a traditional recession driven by the interaction of central bank policy, financial markets, and growth has increased significantly.
- Market participants are advised to monitor the simultaneous shocks of Fed tightening and the Russia-Ukraine conflict for their combined impact on growth, inflation, and asset prices.