David Olive is professor of international economics at the London School of Economics, having spent 15 years as the UK chief economist at the IMF. He tweets at @DavidOliveLSE
With US president Donald Trump imploring global leaders to counteract protectionism and withdrawing from free trade, it may be easy to lose sleep over a new round of stagflation, a heavy bout of inflation.
From the onset of the financial crisis in 2008, UK inflation has averaged about 4% a year. While little, if any, of this is due to trade wars, the likelihood is it will rise as a US-China trade conflict gets worse.
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Yet stagflation is not usually fatal to an economy, and in my view, there are at least two important differences to bear in mind. First, the most serious side-effects of economic tail risks come when the deepest downturn triggers a break-up of the global financial system. In this case, few in the world currently expect a hard Brexit, leaving the probability of economic crash as low as 20%.
Second, stagflation is usually caused by growth diverging from productivity. The British economy, with large public debt and weak productivity growth, was always going to be the weakest performer of the major developed economies, and policymakers should be focused on preventing it from derailing the rest of the world’s revival.
In the past decade, Germany has outperformed both US and UK growth, as a preference for high savings translates into lower interest rates. But the continuing strength of the euro has meant that German export growth has now slowed down.
Of course, if US tariffs drive US businesses out of the UK, we will get even weaker performance. But that is unlikely to happen – not least because Brexit uncertainty is holding back investment and we still expect the output gap to close this year. Furthermore, with real wages having returned to pre-crisis levels, inflation is now at its fastest in four years and appears to be slowing, which should encourage households to consume more and businesses to invest more.
Third, higher energy prices have already dissipated somewhat, with recent data showing only a small increase in the PPI. Moreover, oil prices were much higher when oil was last targeted by the US, and new US threats to close Asian oil markets would encourage producers to keep pumping oil. So I think it is likely that overall inflation will be in the low to mid-2% range for the next couple of years.
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Fourth, I think it is crucial to understand that monetary policy is highly sensitive to wage growth and productivity. When the effective lower bound for interest rates is removed, a few tenths of a percentage point per year of growth in either could add up to a lot of money, as the Fed learned in the 2008 crisis. In the absence of “asymmetric zero sum game” on exchange rates, I believe that aggregate demand will be so weak that a greater movement of asset prices will be judged largely by government financing needs.
I am convinced that if our strong productivity growth is going to be sustained, we need to focus on productivity growth and rather than looking for a trade deal, capital and labor mobility – and we will see a few good days in the UK market.