Central Banks Face Stagflation Dilemma Amid Energy Shock, Echoing 1970s and 2022

Central banks, including the ECB, are currently grappling with an inflation dilemma reminiscent of the 1973 oil price shock. In 1973, Arab nations cut oil production, quadrupling prices. Central banks, fearing impact on employment, were slow to hike interest rates, leading to stagflation by 1975, with Ireland's inflation reaching 21%. The US Federal Reserve initially cut rates in late-1973, then tightened, then loosened again as unemployment rose, a pattern mirrored elsewhere.

The miscalculation of 1973 led to a more hawkish response in 1979 when the fall of the Shah in Iran caused another oil shock. US Federal Reserve chairman Paul Volcker raised interest rates to 20% in 1980-1981, causing a recession but taming inflation. Deutsche Bank notes that policymakers often overcorrect for past mistakes.

After the 2008 financial crisis, the slow recovery led to a perception that interventions were insufficient. Consequently, central banks adopted a more hawkish approach during the 2020 pandemic, with the ECB launching the Pandemic Emergency Purchase Programme (Pepp) of €1.85 trillion by December 2020.

In 2021, inflation surged, but central banks initially deemed it transitory until Russia's invasion of Ukraine in 2022. The ECB began raising interest rates in July 2022, when inflation was already triple its 2% target. This perceived underreaction now drives a hawkish stance. ECB president Christine Lagarde warned against hesitation, and Bundesbank president Joachim Nagel and Slovakia's central bank governor Peter Kazimir indicate further rate hikes are likely. The ECB's challenge is to curb inflation without stifling fragile eurozone growth, which barely grew in Q1. Lagarde dismisses 1970s-style stagflation fears due to strong employment, but higher energy and food prices' full impact is yet to be seen. Deutsche Bank predicts a fresh inflation surge from an energy shock, but believes policymakers will avoid past mistakes.