Jangrim Ha, M. Ayhan Kose, Franziska Ohansarg 12 July 2022

With decades of high inflation, the global economy is in a recession of rapid growth. Global inflation forecasts for 2022-23 have been sharply upgraded, while global growth forecasts have been lowered compared to last year (Figure 1). This combination of high inflation and weak growth has raised concerns about a possible long-term stagnation period similar to the 1970s (DeLong 2022, Verwey et al. 2022). Some argue that central banks need to raise policy rates quickly to keep pace with inflation (Buiter and Sibert 2022, Domash and Summers 2022).

This historical precedent also raises concerns about the risks of the debt crisis in emerging markets and emerging economies (EMDEs), reminiscent of the early 1980s when controlling inflation required a sharp rise in policy interest rates.

Figure 1 Global Growth and Inflation Forecast

Formula: Consensus Economics; World Bank.
Note:: Growth forecasts for the aggregate group are weighed against the US dollar by GDP based on 86 countries, and inflation forecasts are based on the average of 83 countries. Last observed June 2022.

Another traumatic cycle on the horizon?

By some measures, today’s inflation is higher than in the early 1980s (Bolhuis et al. 2022). Looking ahead, global inflation is expected to be at its highest this year and down to about 3% by mid-2023 as global growth slows, monetary policy tightens, financial aid is withdrawn, commodity prices fall and supply disruptions ease. Is. It will still be about one percentage point higher than its average in 2019 For now, the unanimous forecasts suggest that inflation expectations anchor well in the medium term, even if inflation may rise in the short term.

However, there is a risk that inflation expectations will eventually be anchored, as they did in the 1970s, as a result of persistent target-exceeding inflation and repeated inflationary shocks. Concerns about rising inflation have already led central banks in many developed economies and many EMDEs to tighten monetary policy. Financial markets are now expecting a 200-400 basis point increase in monetary policy by the US Federal Reserve, ECB and Bank of England by 2022-23 to bring inflation back to target in these countries. Such a tight cycle would be moderated by historical values ​​(Figure 2).

Figure 2 Interest rates and inflation during the US tightening cycle

Formula: Federal Reserve Economic Data; Havers Analytics; World Bank.
Note:: The blue bars show an increasing rate of growth in US policy during the previous Federal Reserve tightening cycle: 1979-81, 1983-84, 1986-89, 1994-95, 1999-2000, 2004-06, 2015-15. The 2023 value is an estimate based on market expectations for the Fed Funds rate level in mid-2023. The red bars show the core CPI inflation rate, the latest data for 2022-23.

If inflation expectations are unexpected, the increase in interest rates needed to bring inflation back to the target could be much higher than currently expected by financial markets. For comparison, in the 1970s, it doubled global interest rates to 14% in six years (1975-1981). In 1979-1981 alone, the U.S. policy rate increased by nine percentage points to 19%. The increase in the rate of this synchronous policy around the world led to the end of Great Inflation. However, they triggered a global recession in 1982 and gave birth to a series of debt crises at EMDE in the 1980s (Ha et al. 2022a, 2022b).

Large debt accumulated: then and now

In the 1970s and early 1980s, as at present, high debt, high inflation and weak revenue positions weakened the EMDE to tighten financial conditions. The stagnation of the 1970s coincided with the first global wave of debt savings in the last half-century (Figure 3, Kos et al. 2020). Low global real interest rates and the rapid development of the syndicated debt market have encouraged the growth of EMDE debt, especially in Latin America and many low-income countries, especially in sub-Saharan Africa.

Figure 3 Debt and interest rates

Formula: Federal Reserve Economic Data; Haver Analytics; International Monetary Fund; Kos et al. (2020); World Bank.
Comments: A. GDP-weighted average based on 153 EMDE samples. The four waves of broad-based debt formation at EMDE since 1970 include the following: 1970-89; 1990-2001; 2002-09; After 2010; B. Figure shows the average annual change of total debt. The rate of change is calculated as the total increase in the debt-to-GDP ratio over the duration of a wave, divided by the number of years of a wave; C. External debt (percentage of GDP) is based on a GDP-weighted average of up to 137 EMDE. The foreign exchange share of government debt averages 36 EMDEs; D. The figure shows nominal and real (CPI-adjusted) short-term interest rates (Treasury bill rate or money market rate, with maturities of three months or less). Global interest rates are weighed by GDP in US dollars. There are 113 countries in the sample, although the size of the sample varies from year to year.

The tightening of monetary policy in developed economies has sharply increased borrowing costs, particularly in Latin America and the Caribbean (LAC), where variable rate debt is more than half of total debt in 1982. , Averaged 1.6% of GDP in 1975-79 and 5% of GDP between 1982. A steep growth recession further weakens the power of credit services In the 1980s, more than three dozen debt crises occurred, mostly in the LAC and sub-Saharan Africa (Figure 4).

Figure 4 Financial crisis and weakness in EMDE

Formula: Kos et al. (2020); Haver Analytics; International Monetary Fund; Leven and Valencia (2020); World Bank.
Comments: A. The total number of banking, monetary and sovereign debt crises in the EMDE over its own term; B. Median based on 155 EMDE samples.

If it is now necessary to raise policy rates again to bring inflation under control in a developed economy, EMDEs will again face a tough challenge. Total EMDE debt is a record high of 207% of GDP. EMDE public debt, at 64% of GDP, is at its highest level in three decades, and about half of it is denominated in foreign currency, and more than two-fifths is in the hands of non-residents of the intermediate EMDE (Kos et al. 2022). The sharp rise in borrowing costs – or the sharp currency devaluation that often accompanies tightening policy in developed economies – could again lead to a sovereign debt crisis because the economy now has a greater vulnerability than ever before. About 60% of the poorest countries are already in a debt crisis or at high risk.

Getting ready

If inflation stays above the target for a long period of time, there is a risk that inflation expectations will be unexpected. Achieving the same inflation target would then require a much larger policy rate increase in a developed economy. Combined with the high debt of many EMDEs and the large financial and current account deficits, these economies are likely to face financial pressures in the wake of the global growth slowdown. These risks are particularly high among EMDEs that have large current account deficits and rely heavily on foreign capital inflows, as well as high levels of short-term or foreign exchange-determined public or private debt. These economies need to be prepared for the stormy weather associated with the hardening cycle. It starts with a careful calibration, credible formulation and clear communication of their principles.

References

Bolhuis, MA, JNL Kramer and LH Summers (2022), “Past and present inflation is much more than you think,” VoxEU.org, 22 June.

Buiter, W and A Sibert (2022), “Central Banks Still Behind Inflation Curve,” Project Syndicate, 9 June.

DeLong, JB (2022), “Why the US Federal Reserve Options Are Limited,” Project Syndicate, 14 June.

Domash, A and LH Summers (2022), “Extremely hot conditions indicate high probability of a U.S. recession,” VoxEU.org, 22 April.

Ha, J, MA Kose and F Ohnsorge (2022a), “Global Stagflation”, CEPR Discussion Paper 17381.

Ha, J, MA Kose and F Ohnsorge (2022b), “Today’s inflation and the Great Inflation of the 1970s: Similarities and Differences”, VoxEU.org, 30 April.

Kose, MA, F Ohnsorge and N Sugawara (2022), “A Mountain of Debt: Navigating the Legacy of the Pandemic,” World Bank Policy Research Working Paper no. 9800.

Kose, MA, P Nagle, F Ohnsorg and N Sugawara (2020), Global debt wave, Washington, DC: World Bank.

Kos, MA, N. Sugawara and M. Terons (2020), “Global Recessions”, World Bank Policy Research Working Paper 9172.

Laeven, L and F Valencia (2020), “Systemic Banking Crisis Database II”, IMF Economic Review 68 (2): 307-361.

Verwey, M, L Bardone and K Orsini (2022), “Russian Invasion Tests EU Economic Resilience,” VoxEU.org, 20 May.

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