The Federal Reserve’s monetary policy, consisting of aggressive rate hikes combined with balance sheet contraction, aims to achieve price stability through lower inflation. The Federal Reserve believes it can effectively reduce inflation without triggering a recession. While this is a possible outcome, achieving this goal will be extremely difficult at best and impossible to achieve at worst.
The Russian invasion of Ukraine has had a profound impact on commodity prices, supply chains, inflation and a sharp contraction in global growth. The impact of the war in Russia is that the Federal Reserve can only influence core inflation, resulting in no major real reduction in inflation and an economic contraction. A key risk to the global economy, therefore, is the possibility that inflation will remain persistent and high, along with contracting economic growth, the definition of stagflation.
At present, inflation worldwide continues to rise exceptionally high. Today, the European Union reported that inflation reached a new all-time high in June. Headline inflation in Europe was 8.6% year-on-year and exceeded the inflation rate in the United States of 8.3% (CPI value for May). Inflation in advanced economies is currently at its highest level in 40 years.
Global growth recovered to 5.7% in 2021, but most of the global growth that occurred in 2020 and 2021 was supported by easing global fiscal and monetary policy. As this lodging has ended, economic growth is expected to contract to 2.9% by 2022. More alarmingly, global growth is likely to continue contracting in 2023 with little change.
Today, the Brookings Institution published an in-depth study of how “the current global economy is uncannyably like the 1970s.” This study acknowledged that “the global economy is in the midst of a sudden slowdown accompanied by a precipitous rise in global inflation reaching highs of several decades. These developments raise concerns about stagflation – the coincidence of weak growth and high inflation – similar to what the world suffered in the 1970s.”
This study finds that the current supply shocks arose after the prolonged easing of monetary policy led to pent-up demand combined with the recent global supply shock in food and energy costs resulting from the Russian invasion of Ukraine. According to the study, the global economy faces challenges similar to the oil shocks that occurred in 1973 and 1979-80. The study concludes that, as in the 1970s, the global economy could enter a period of stagflation.
There are multiple possible outcomes of global central banks and the Federal Reserve’s monetary tightening. Their intended goal is to successfully reduce inflation and the soft economic landing at the same time. While this is the desired outcome, it will be the most challenging possible outcome to achieve. There is a real risk that their actions will lead to persistent and high inflation coupled with economic stagnation.
If the global economy enters a period of stagflation, it will certainly create a strong bullish undertone for the gold price. This can be seen in today’s price action in gold. Gold futures traded as low as $1783.40 last night and is currently fixed at $1812.12 indicating a dynamic pivot and possible key reversal. We could witness market participants focusing on the real possibility that global central banks’ monetary policies will lead to stagflation rather than their intended goal of lowering inflation.
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