Stagflation lite? Risk of stagflation grows, though unlikely a repeat of 1970s

Canada is leaning toward a new era of 1970s-style stagflation as the pace of economic growth slows yet inflation remains stubbornly high, economists say.

The abnormal mix of rising prices and high joblessness gripped the country 40-odd years ago.

Supply shocks sent energy costs soaring, interest rates climbed to devastating heights and unemployment was rampant.

Now some experts say conditions are ripe for a return of the economic phenomenon.

“I would say in the next year we’re looking at a recession in this country, which in combination with continued inflation could spell stagflation,” said Armine Yalnizyan, an economist and Atkinson Foundation fellow.

“We can’t duck the global forces that are pointing at recession … the question is whether raising interest rates will slow inflation.”

While stagflation could make a comeback, it would likely be a more mellow version of the economic anomaly – a sort of stagflation-lite.

“I don’t think it’s unrealistic to expect that we could see a world where we have higher inflation and higher unemployment,” said Fred Bergman, a senior policy analyst with the Atlantic Provinces Economic Council, an independent Halifax-based economic think tank.

“We could see those two tracking up, which is rare. But it’s going to be very modest compared to what we saw back in the 1970s and 1980s.”

The simultaneous increase in inflation and unemployment stumped economists and policymakers in the 1970s.

Economics 101 would say the macroeconomic issues of inflation and unemployment have an inverse relationship. High inflation occurs during periods of low unemployment and vice versa.

Stagflation topples this theory by pairing high inflation with rising joblessness and slowing growth.

Solving it is a conundrum. The levers used to tackle inflation could slow the economy and ratchet up joblessness, while efforts to spur economic growth could fuel rising prices.

“This creates a bit of a quagmire for policy people,” Bergman said. “When the inverse relationship between unemployment and inflation is upended, it leads to a policy dichotomy.”

The challenge facing the Bank of Canada is raising interest rates enough to tame inflation but not triggering a recession.

In an unprecedented move, the central bank hiked its key interest rate for the second time in two months on Wednesday, bringing its policy rate to 1.5%.

But it’s unclear whether it will be enough to temper inflation.

The annual pace of inflation rose to 6.8% in April, the fastest year-over-year rise in more than three decades.

Finding the interest rate sweet spot is complicated by the fact that there’s a lag effect between higher rates and the influence on consumer spending and business investment.

“They’re walking a fine line and it’s a bit of a balancing act,” Bergman said. “We’re going to see the economy slow down and … we could move to the borderline of a recession.”

In a speech last month, Bank of Canada deputy governor Toni Gravelle said comparisons between rising inflation now with the stagflation period of the 1970s aren’t justified.

“We don’t see the stagnant part of stagflation _ quite the opposite,” he said. “The Canadian economy, across many measures, is running pretty hot.”

While higher interest rates will reduce demand and slow growth, they should also reduce inflation – undercutting the inflation component of stagflation, he said.

The trouble is, it might not, economists say.

Some factors pushing up prices in Canada are likely to continue despite higher interest rates.

“There are other forces that could keep inflation high, even though the economy is going down,” said Nicolas Vincent, an economics professor at HEC Montreal.

“We keep getting hit by supply shocks.”

Russia’s invasion of Ukraine, Covid-19 lockdowns in China and backlogged supply chains are all fuelling higher prices.

These situations are likely to continue.

“The invasion of Ukraine and the China experience guarantees that we are looking at at least another year of this until price pressures start to unwind,” Yalnizyan said.

“The easiest tools we have in our tool box are central bank policies, which themselves will slow growth but they risk making the situation worse not better … it’s a tightrope exercise.”

The stagflation problem that started in the 1970s only ended in the early 1980s when the Bank of Canada hiked interest rates to the point where the prime lending rate soared to above 20%, the Conference Board of Canada said in a recent analysis.

“Inflation and inflation expectations eventually plunged, but the cost was a brutal recession that saw the unemployment rate hit 12% in the early 1980s,” the Conference Board said in the March report.

In other words, the remedy used to fix inflation could cause nearly as much pain in other areas.

Still, several conditions today are different than in the 1970s and could help Canada dodge stagflation.

Canada’s unemployment rate fell to a record low of 5.2% in April, Statistics Canada said last month.

The robust jobs market and ongoing labour shortage in several industries across the country is in stark contrast to the high unemployment recorded when baby boomers were young four decades ago.

“The labour market is running really hot,” said William Robson, president and CEO of the C.D. Howe Institute, a Toronto-based think tank.

“There are parallels to the 1970s but our unemployment rate is in a much better place.”

Demographics and an aging population will also help keep joblessness at bay, he added.

Canada could benefit from ongoing higher commodity prices, potentially even fuelling a higher trade surplus.

Meanwhile, the country has significantly less unionization with fewer cost-of-living allowances baked into collective agreements and contracts.

“Workers in the past tried to catch up to price increases because otherwise they would be losing purchasing power,” Yalnizyan said. “It led to a price-wage spiral where the one just kept feeding the other.”