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Stagflation shock in 2022 and its effect on EMDEs

Stagflation refers to an economic period of high inflation, slow economic growth, and relatively high unemployment. These risks loom large, owing to high inflation, the war in Ukraine, and slower growth in China. Pre-existing macro-financial vulnerabilities magnify the risks, which could disrupt financial systems and strain emerging market economies globally. However, the word is resurfacing the face of the internet with a search for the term spiking amid signs of a global energy crunch, it is not a recent trend. The stagflation of 1970 is a good example. The June Global Economic Prospects report offers the first systematic assessment of how current global economic conditions compare with the stagflation of the 1970s—with a particular emphasis on how stagflation could affect emerging markets and developing economies.

The recovery from the stagflation of the 1970s required steep increases in interest rates in major advanced economies, which played a prominent role in triggering a string of financial crises in emerging markets and developing economies. A Forbes report shows that the world is not in stagflation, but it is likely coming. The first result is employment falls, and only later does inflation decline, this is also known as the time lag in monetary policy. The graph illustrates how much of the overall influence happens at a specific period. About half of the whole impact on employment has already been felt six months into the fiscal tightening, with the other half still to come. However, because business costs rose as a result of rising interest rates, inflation is now worse.

The impact on inflation is only beginning after a year of monetary tightening, while the effect on employment is almost complete. The employment misery is lessening a year and a half later, but we still haven't fully benefited from lower inflation. But eventually, inflation does decline. Employment will ultimately recover from the blow. With the light of this time lag expected, Forbes projects will show early signs late in 2022 and get roaring in 2023. By the end of that year, the risk of recession is expected to be much higher, even though inflation will just be starting to decline, hitting stagflation. Bloomberg also states that stagflation is the key risk for the global economy in 2023, according to investors who said hopes of a rally in markets are premature following this year’s brutal selloff.

According to the World Bank’s latest Global Economic Prospects report, the compounding damage from the COVID-19 pandemic, and the Russian invasion of Ukraine has magnified the slowdown in the global economy, which is entering what could become a protracted period of feeble growth and elevated inflation. The reports found three similarities that resemble the early 1970s: supply shocks and elevated global inflation in the near term, preceded by a protracted period of highly accommodative monetary policy in major economies, together with recent marked fiscal expansion; prospects for weakening growth over the longer term, which echo the unforeseen slowdown in the potential growth of the 1970s; and vulnerabilities in EMDEs to the monetary policy tightening by advanced economies that will be needed to rein in inflation.

The implication is that EMDE policymakers are facing the first significant global monetary policy tightening cycle after more than a decade of highly accommodative external financial conditions and in the midst of a major energy and food price shock. Amid deteriorating growth prospects and until inflation is reined in again, they may need to adjust to more expensive borrowing terms. Notwithstanding differences in some of the specifics of these policy challenges, EMDE policies will require careful calibration, credible formulation, and clear communication.


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