The Stagflation Dilemma – Why Central Banks Should Be Worried?

Lately, the issue of stagflation has become the main concern of central banks and citizens. It is one of the most complicated situations in our modern economy which characterizes by rising prices and an economic recession. And every central bank in the world is currently facing a huge dilemma – raising interest rates, obviously. But to what extent?

So, what is the problem with stagflation?

Well, stagflation is a bizarre economic condition where prices rise and at the same time, the market is facing an economic recession or slowdown. As the name implies, stagflation is characterized by stagnant economic growth, a high inflation rate, and a high unemployment rate. Long story short, a headache for central bankers.

The real problem with stagflation is how to get out of it. In normal market conditions, when there’s a high growth, central banks can increase rates and decrease public and private spending in order to reduce the amount of money in the market. On the other hand, when there’s a recession, central banks will reduce interest rates and, in some cases, even print money to stimulate the economy. But in stagflation, central banks have to choose their poison – if they raise interest rates too much, they might create an appreciation of their currency and deepen the recession. On the other hand, if they modestly raise interest rates, inflation can continue soaring and increase the unemployment rate.

Choose your poison – inflation or recession?

It all comes down to one question when the stagflation dilemma arises – what is more urgent, taking care of inflation or economic slowdown? In most cases, central banks prefer to deal with inflation before they try to stimulate the economy. Why? mainly because a recession is not such a bad thing. Or, in other words, it’s good for the economy to some extent as long as it’s not a prolonged recession with a sharp decline in production, consumer spending, and rising unemployment rates. Unlike an economic crisis which indicates an error in the economic model and the need to restart the process, a recession is just part of the economic cycle and nature. Everything goes up and down.

Inflation, on the other hand, is the biggest concern for policymakers and politicians. If inflation increases, then it basically means the cost of basic commodities is increasing, which ultimately might cause political instability and even, in some cases like the French revolution, violence.

So, what does it mean when we look ahead at the future? Well, in most countries worldwide the inflation rates are somewhere between 8%-12%. Interest rates? somewhere between 0.75%-1.5%. There’s a long way to go until central banks find the rates that reduce rising prices. This means that stock markets may continue the downtrend or consolidate at the same levels. As for currencies, there’s a tricky situation here. Central banks want a weak currency to stimulate income from export, and thus, increase their GDP. At the same time, they take a risk to strengthen their currency to avoid high inflation rates (which might happen as a result of a weak currency).

So, to sum up, things are quite complicated these days for central bankers when they are facing one of the major problems of the economy – the stagflation dilemma. But one thing is sure – for now, the stock market party is over. And those who said that growth can continue forever in the market conditions, well, guess not…