About the author:
Ding Yifan, Senior Fellow of Taihe Institute
The Financial Times has invented a new term to describe the current global economic situation – “shrinkflation” – an amalgamation of the terms “shrinkage” and “inflation.” The new term aptly describes the situation of the US economy, which in the first and second quarters of 2022 experienced negative growth for two consecutive quarters – a technical recession. In the 1970s, Western economic growth stagnated and inflation remained high, giving rise to the term “stagflation.” Today, inflation has returned while economic growth is simultaneously shrinking. Shrinkflation is a more dangerous state than stagflation due to the confluence of macroeconomic policies gradually failing and the economy entering a state of free fall.
The global inflation headache
In 2021, inflation rates in the United States and Europe started to rise. In 2022, the inflation rate showed signs of escaping fiscal and monetary controls. In the middle of 2022, the monthly inflation rate in the United States passed 8%, and in Europe, exceeded 9%. In the midst of public protests, central banks around the world responded with rapid interest rates rise. The US Federal Reserve successively raised interest rates by 0.75% three times, signaling that other markets should also raise interest rates aggressively.
However, the “Volcker moment”1 did not occur in the United States, and the Federal Reserve began to release “dovish” information on the issue of continuous interest rate hikes. Thus, it seemed that the Federal Reserve would not continue to raise interest rates aggressively in the future. However, the economic growth rates of the U.S. and Europe have stagnated. According to the forecasts of international institutions, over the next two years, the average growth rate in developed countries such as the United States and Europe will be under 1%, inspiring the Financial Times to coin the term “shrinkflation.”
Milton Friedman, an American economist and originator of “monetarism,”2 said long ago that inflation is ultimately a monetary phenomenon. Behind all the hyperinflation in history, there has been a phenomenon of serious oversupply of money. Since the outbreak of the Global Financial Crisis (GFC) in 2008, the central banks of developed economies such as the United States, Europe, and Japan have used unprecedented monetary easing policies to inject a large amount of liquidity into the market. Central banks first slashed interest rates, bringing nominal interest rates down to zero. However, when the market failed to respond, the Federal Reserve embarked on a policy of massive “quantitative easing” (QE) or the direct purchase of bonds in the financial market. The issuance of additional currency is commonly termed “printing money.” Each round of QE, as the Federal Reserve enters the market to buy bonds, first makes a high-profile statement of the purchase quantity. From 2008 to 2014, the Federal Reserve carried out three successive rounds of QE, buying a total of 3.9 trillion US dollars of bonds, which is equivalent to “printing” US dollar cash of the same amount.
The European Central Bank (ECB), the Bank of England (BoE), and the Bank of Japan (BoJ) were competing with the Federal Reserve to see which institution was more inventive. Central Banks continued to implement QE policies, buying bonds to release new liquidity, and more boldly implementing negative nominal interest rates. The British economist John Maynard Keynes had previously diagnosed the contemporary Central Bank policies:
“[M]onetary policy has limits. When the central bank’s interest rate drops to zero, it will fall into a ‘liquidity trap,’ because monetary policy will lose its effectiveness. People would rather put cash under their bed than put it in the bank and wait to be ripped off by the bank.”
Today, the central bankers in many developed countries have ignored Keynes’ diagnosis; thus, they enforced negative nominal interest rates – “whoever puts money in the central bank’s account, the central bank will ask him to pay a tax over this deposit.” In fact, negative nominal interest rates cannot be applied to individuals or enterprises. Commercial banks, however, were unable to resist. All countries have a system of bank statutory deposit reserve, whereby commercial banks must put a certain percentage of their deposits in the central bank’s account to ensure that commercial banks will not lend excessively and prevent depositors from making a “run on the bank” – simultaneous withdrawals that exceed the banks’ cash deposits.
Central banks also raise or lower this statutory reserve ratio as an instrument of monetary policy by adjusting the liquidity in the market. As the central bank implements negative nominal interest rates, and the reserves placed in the central bank accounts by commercial banks become “hostage,” whereby interest must be paid to the central bank, which is equivalent to an additional tax. Theoretically, the negative nominal interest rate is imposed to force commercial banks to release more loans to stimulate investment and consumption. However, during an economic recession, market demand is sluggish, and it is difficult for commercial banks to find borrowers, no matter how willing banks are to lend. As a result, after a sustained period of negative interest rates in the economies of Europe and Japan, those economies have not been able to significantly rebound.
The actual role of negative nominal interest rates is to curb the yields of national debts issued by a particular country. Since the last round of financial crises in the developed economies, debts have risen, and debt interest has become an onerous financial burden. The negative nominal interest rate of the BoJ makes the annual yields rate of Japanese debts less than 1%, which is significantly lower than the inflation rate, which greatly increases the sustainability of Japan’s national debts.
While the central banks of the United States, Europe and Japan have released a large amount of extra-liquidity, inflation had remained relatively low. The main reason resides in the development of the international financial market and the power of globalization. Currencies such as the US dollar are hard currencies. When the interest rates of these currencies are cut sharply, bonds priced in these currencies are relatively inexpensive, and currency price differentials allow international investors to engage in arbitrage. As such, a large quantity of available liquidity went to emerging economies, thereby reducing inflationary pressure on their currencies. Moreover, in the past few years, globalization had allowed many emerging economies to produce a large number of lower-cost manufactured goods for the developed economies, keeping consumer prices and inflation low.
The straw that breaks the camel’s back
When new liquidity is released, it can flow to new international investment markets or to new investment darlings in the financial market and inflation may not immediately rise. However, changes in the geopolitical landscape during 2022 were unexpected and due to the interaction of negative factors, inflation has both risen and remained high.
First, the COVID-19 pandemic has persisted and mutated into more contagious variants, infecting millions more people globally. As such, labor forces in many emerging economies have been seriously impacted and manufacturing production has been disrupted. The epidemic’s rebound also severely interrupted commercial activities in the United States, especially commodity logistics; thus, goods could not reach enterprises or consumers. Ports in the United States, such as Long Beach, were overflowing with containers, but there were no trucks to transport them. The resultant commodity shortages led to higher prices and created significant new inflationary pressures.
Second, the COVID-19 pandemic made many developed countries realize that their national security was vulnerable to long supply chains. Most notable was that the production of basic medical protection products could not be guaranteed. Therefore, governments in the United States, Europe, and other countries were determined to initiate re-industrialization programs. They have adopted legislation that requires their enterprises to on-shore, and have stipulated minimum proportions for domestic components in critical manufacturing industries. These “anti-globalization” activities not only restrict international trade, but also greatly increase the cost of production, further increasing price pressure and inflation.
Finally, the war in Ukraine has triggered comprehensive economic sanctions against Russia by the United States and Europe, causing the interruption of commodity circulation channels between Russia and Europe. Both Russia and Ukraine are important suppliers in the world’s grain and energy markets. The war has hindered Ukraine’s grain and oil exports, Russia’s exports have been banned, and the prices of grain and energy in the international market have skyrocketed. Food and energy prices are the core inputs, and their price increases are reflected along all supply chains, exacerbating overall prices and core inflation rates globally.
The central bank policy dilemma
In 2020, the US stock market plummeted due to the economic downturn caused by the COVID-19 pandemic. The stock market used the circuit breaker mechanism three times in a row to prevent market panic. However, the stock market continued to decline. Thus, the Federal Reserve responded by adopting a brutal policy of “limitless easing,” making massive purchases of bonds in the market and releasing massive liquidity into the market. Immediately following the Federal Reserve’s decision, the market cooled. Traders dared not second-guess the Fed and the stock market returned to normal. However, the Federal Reserve paid a high cost due to the total issuance of liquidity far exceeding the three previous rounds of QE and vast sums changing direction under the dual pressure of the pandemic and geopolitical maneuvering.
The United States also relied on the Federal Reserve’s excessive currency issuance to maintain financial market stability, but the Fed was constantly overdrawing its credit, which placed it in a very precarious situation. Before the 2008 GFC, the Federal Reserve had 800 billion US dollars in bonds on its balance sheet; after several rounds of bonds purchases, the balance sheet of the Federal Reserve had accumulated 7 trillion dollars of bonds, which reached 8 trillion dollars by 2021. Compared with that in 2008, the Fed’s balance sheet had increased by a factor of 10, and was twice as large as before the pandemic. The Fed faced the threat of bankruptcy if the US bond market were to collapse. The Fed was facing a perilous dilemma: if it sold bonds, prices would fall and the Fed’s losses would increase; if it increased its holdings, the risk also increased, because the risk of a market crash similarly increased.
Before the 2008 GFC, the Dow Jones index on the New York stock market was more than 14,000 points, and economic commentators warned of a gigantic bubble. As the GFC unfolded, the Dow Jones index plummeted below 5,000 points. However, after several rounds of monetary policy operations by the Federal Reserve, the stock market soared. At the beginning of 2022, the Dow Jones index had risen to more than 36,000 points and many investors began to realize they faced an abyss.
Both “shrinkflation” and “stagflation” create a dilemma for governments’ macroeconomic policies. To curb inflation, economic contraction ensues; to stimulate economic growth, control of inflation is lost. In the 1970s, after many years of stagflation, the United States and Europe finally began to focus on controlling inflation, ruthlessly tightening monetary policies and vigorously raising interest rates; inflation was suppressed, but at the cost of economic recession. To deal with the new onslaught of “shrinkflation,” the developed countries have begun to adopt extreme monetary tightening policies to quash inflation and cause another round of economic recession.
A shadow over global recovery
The decision by the central banks of major advanced economies to raise interest rates in response to resurgent inflation has placed many developing countries in perilous financial straits. As the Federal Reserve raised interest rates, the appreciation of the dollar attracted a large amount of capital back to the United States. The capital flight from many emerging economies caused their currencies to depreciate sharply. The Turkish lira depreciated by nearly 30%, the Brazilian real by 6.2%; the Indian rupee by 7%, the South African rand by more than 4.5%, the Vietnamese dong by more than 6.4%, the Indonesian rupiah by more than 10%, and so on. This caused financial market indexes in many emerging economies to also decline sharply and corporate financing tightened, adversely affecting economic growth. The depreciation of local currencies causes the cost of imported raw materials and energy to rise, creating imported inflationary pressures. To alleviate the pressure of depreciation, central banks in some emerging economies began intervening in the market, selling dollars and buying local currency. However, the intensification of capital flight also depletes foreign exchange reserves, further weakening the economy, and financial crises may ensue. This phenomenon caused the Latin American debt crisis in the 1980s and the Asian Financial Crisis (AFC) in the 1990s.
The large amount of external funds that flowed to the United States, in the wake of its rate hikes, was not good news for the U.S. either. For example, when the Federal Reserve raises interest rates, US treasury bond interest rates rise accordingly, and US government interest payments on treasury bonds also rise sharply. When US government debt is low, rises in interest payments pose no threat to government finances. However, since the 2008 GFC, the fiscal and financial situation in the United States has continued to deteriorate. In 2000, the US federal debt level accounted for just over 50% of GDP; by early 2022, US government’s debt of over 30 trillion US dollars had reached more than 120% of GDP. As the interest rate on the US national debt rises, the fiscal expenditure of the US government also increases significantly. The US Congressional Budget Office has predicted that debt interest payments will soon become the largest expenditure item of the US government, surpassing military spending. If so, the United States and the world are on the precipice of another debt crisis.
In this context, the Fed is caught in yet another dilemma. By not raising interest rates, negative public expectations of long-term inflation rates increase, causing the US economy to fall into long-term stagflation and rendering macroeconomic policies ineffective. However, raising interest rates sharply may cause the underlying financial bubble in the market to burst, resulting in a financial crisis more serious than the 2008 GFC, and plunging the economy into a long deep recession. Moreover, if the Federal Reserve hesitates and US dollar hegemony over the international monetary system remains unchanged, the global economy will be severely restrained by the US economy and may fall into disorder. Of course, some international capitals view financial market chaos as an opportunity to fish in troubled waters.
Can the threat of global shrinkflation be eliminated?
Despite the efforts of the Fed, ECB, BoE, and BoJ to seek urgent alternatives to curb inflation and achieve a “soft landing” for their economies, shrinkflation has demonstrated no signs of improvement. In fact, central banks globally need to change their mindset to exit the increasingly dark shadow of global shrinkflation.
Not long ago, some economists explained that robust global economic growth and low global inflation were due to the rapid development of globalization. However, the developed economies are now pinning their hopes on monetary policy adjustment as a panacea and disregarding the growing risks of global financial instability. The persistence of the Cold War mentality restrains the G7 from re-embracing free trade and strengthening international cooperation to regain the full efficiencies of global supply chains and their significant cost advantages. Easing geopolitical pressures would also stabilize and reduce the cost of key raw materials such as energy and food, and global inflationary pressures would substantially decrease.
To change the mindset of the developed countries, led by the United States, they must be reminded that only by rebuilding mutual trust and international cooperation can the world find a path to curb global inflation and promote growth. At the G20 summit held in Indonesia, President Xi Jinping once again emphasized that the members of the G20 are major economies in the world, and should embody the responsibility of big powers, play an exemplary role, and seek development for all countries, for the well-being of mankind, and for the progress of the world.
“With human civilization already in the 21st century, the Cold-War mentality has long been outdated. What we need to do is to join hands together and levate our win-win cooperation to a new height. Countries should respect each other, seek common grounds while reserving differences, ive together in peace, and promote an open world economy.”
The pursuit of anti-globalization policies by the developed countries has only resulted in the dilemma of high inflation and weak economic growth for the global economy. The era of Planetization and the “global village” has arrived. Whether it is climate change, the spread of the pandemic, or even a global economic recession, people everywhere face similar challenges and difficulties. Only by uniting, showing solidarity and assisting one another can global inflation be curbed, systemic economic and financial risks be avoided, and a new impetus for global economic growth be discovered to build a shared future for mankind.
1. The US Federal Reserve board led by Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. The prime rate rose to 21.5% in 1981 as well, which helped lead to the 1980–1982 recession, in which the national unemployment rate rose to over 10%.
2. Monetarism is a school of thought in monetary economics that emphasizes the role of governments in controlling the amount of money in circulation. Monetarist theory asserts that variations in the money supply have major influences on national output in the short run and on price levels over longer periods.
Please note: The above contents only represent the views of the author, and do not necessarily represent the views or positions of Taihe Institute.
This article is from the December issue of TI Observer (TIO), which is a monthly publication devoted to bringing China and the rest of the world closer together by facilitating mutual understanding and promoting exchanges of views. If you are interested in knowing more about the October issue, please click here:
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