High inflation, but context different from the 1970s

The current high inflation in the Netherlands occurs in a different economic environment than in the 1970s. Back then, the labor market, the companies’ financial position and monetary policy were fertile ground for stagflation.

Now also a negative supply shock

In the 1970s, as now, the economy had to struggle with sharply rising oil and food prices. This led to high inflation and over time also to an economic downturn in the early 1980s. This combination is called stagflation (see figure). Stagflation can generally be caused by an unexpected decrease in the availability of production resources, such as building materials or energy. As a result, the supply of goods and services decreases, leading to general price increases if demand remains the same.

The economy is still struggling with high inflation following a negative supply shock. Disruptions in supply chains and the consequences of the Russian invasion of Ukraine have made raw materials and semi-finished products more scarce and more expensive. This hampers the companies’ production possibilities and, just like in the 1970s/80s, poses downside risks for economic growth. However, the current situation is not expected to lead to a comparable period of stagflation again (see the estimates for 2023 and 2024 in the figure). While there are certainly conceivable scenarios for growth to be negative in 2023 and underlying in 2022 (EPC June 2022), the combination of negative growth and high inflation will still not be comparable to the 1970s/80s.

Differences with stagflation period

Back then, wages rose automatically with inflation. This automatic price compensation – which was in force in the Netherlands until 1982 – stimulated a wage-price spiral. The salary expense per employed increased significantly more than labor productivity. It eroded the companies’ competitive position and profits. As a result, business investment fell. In the deep recession that followed, Dutch unemployment rose to more than 10% of the workforce in the early 1980s.

In general, nominal wages are now no longer automatically linked to inflation. Although the current tight labor market is contributing to wage growth, the expected wage increases this year even lag behind inflation on average. As a result, real wages will fall this year, on average across the entire Dutch economy (see DNB estimate in EPC June 2022).

Dutch business is in much better shape now than it was then. In 2020-21, the average profit margin for all non-financial companies was 40%. In the period between 1972 and 1982, this was 34%. As a result, companies generally now have more room to absorb temporarily higher labor costs.

Moreover, economic and monetary policy is different now than it was then. Monetary policy today focuses on price stability and aims to keep the inflation expected by households and businesses close to the inflation target. At that time, politicians generally pursued an easy monetary policy.

It was assumed that this will have positive effects on employment in the long term. However, this policy also fueled inflation. In the first half of the 1970s, this was accompanied by relatively high economic growth (see figure). However, the combination of high inflation and high growth proved unsustainable.

High inflation is ultimately detrimental to growth

In the long term, higher economic growth and lower unemployment cannot be achieved by allowing inflation to rise. In fact, recent work by DNB researchers shows that too high inflation damages the growth potential of the economy. From this perspective, a tightening of monetary policy with a view to price stability also ultimately supports the economy and employment. This reduces the risk of a new period of stagflation.

Note: Stagflation is defined as a year in which the annual growth in real GDP per population is 0% or below and inflation is above the average plus 1 standard deviation (which corresponds to an inflation rate of 5.8% or above, measured over the period 1970-2021, years). Inflation is CPI in 1970-1996 and HICP from 1997. Inflation and GDP growth per per capita in 2022-2024 are the DNB estimates in EPC June 2022.

Leave a Comment