Stagflation, what are the implications for savings?

To describe it, analysts use a technical term: stagflation, a word that is the result of the crasis of two other words (stagnation and inflation, precisely) and that indicates a situation in which consumer prices are rising at a rapid pace (inflation) even though, at the same time, the economy is not growing (stagnation) or is even in recession.

What does the beginning of such a phase entail?

For economic operators, this is certainly not good news. Usually, in fact, inflation is accompanied by periods of economic growth, when consumption and incomes also rise and there is high demand for goods and services on the market. It may happen, however, that price growth, in addition to an increase in consumption, is generated by other factors such as increases in commodity prices, primarily energy prices. This is precisely what happened in the 1970s when there were oil crises related to tensions in the Middle East. And it is what happened in recent months when war broke out between Russia and Ukraine, two major commodity producers. The outbreak of the conflict and international tensions exacerbated the commodity price increases that had already occurred in previous months, linked to a recovery in global demand after the hard months of the Covid-19 pandemic. Here then is when the scenario becomes complicated and inflation, instead of accompanying growth, is accompanied by a weakening of the economy.

To stop the price flare-up, central banks are raising interest rates, trying to keep consumption at bay and reduce money circulation (which is always a driver of inflation). The U.S. Federal Reserve has already done so, raising them by 0.75 percent to 1.5-1.75 percent in mid-June. And so will the European Central Bank (ECB) soon, which is likely to raise rates by 0.25 percent in July and then prepare for another tightening in September as well.

Also moving in the same direction in mid-June was the Swiss Central Bank, which still has negative rates but adjusted them upward by half a point, from -0.75 percent to -0.25 percent. The only one bucking the trend is the central bank of Japan (Bank of Japan), which does not seem intent on raising the cost of money, keeping it in negative territory (-0.1%). Which has paved the way for a devaluation of the yen in the foreign exchange market, for understandable reasons given that financial assets denominated in the Japanese currency yield less than those of other countries and have lost appeal among international investors.

Apart from the Chinese exception, with the PBoC promoting an accommodative monetary policy to stimulate the country's recovery like Japan's, many observers today question whether raising rates is really effective in curbing inflationary pressures. In the United States, there is undoubtedly a flare-up in consumption pushing prices, and not a few economists believe that the Federal Reserve has moved even too late to curb demand. In Europe, on the other hand, there are those, such as Francesco Giavazzi, a Bocconi professor and government economic adviser, who rather believe that the ECB made a mistake by deciding to raise rates. In Europe, according to Giavazzi, there is no consumption-generated inflation as in the United States but mainly due to commodity price increases, given the heavy dependence on Russian gas of some Old Continent countries. So, again according to Giavazzi, a rise in the cost of money in the short term could prove ineffective or even counterproductive.

On the aspects highlighted above, Tommaso Monacelli, professor of economics at Bocconi University in Milan, and fellow of the IGIER Bocconi and CEPR research institutes in London, takes a different view. While it is true that the situation in Europe and the United States is different, for Monacelli the substance does not change much. In the United States, there is yes, inflation also driven by consumption (not coincidentally, it is higher than in the Old Continent) but, on both sides of the Atlantic, what should be of concern, however, is the rise in prices linked mainly to a supply shock, for what is happening in the commodities market.

In such a scenario, Monacelli says, "central banks do not have to act in a piecemeal fashion, but rather they have to give a decisive response, signaling their future actions." In other words, monetary policy authorities must "announce today what they will do tomorrow and the day after tomorrow, so as to better manage inflation expectations, which are the main driver of inflation. And this is especially true when price increases involve goods that have a big impact in the consumption basket such as gasoline, electricity or heating."

The Bocconi professor was making these remarks back in March, but, unfortunately, months later, it cannot be said that central banks, accused by many observers of moving late, have moved in the direction he advocated in time. "Making monetary policy choices in a phase of economic growth is quite easy," Monacelli continued, "but, in a scenario like the current one, things are much more complicated."

In other words, today's central bankers have to juggle a difficult balancing act in which they are forced to weigh two variables on the scales: to stop the flare-up of inflation, interest rates have to be raised, but at the same time, such a rise ends up having negative effects on the growth of an economy that is already slowing down.

Beyond judgments about the actions of central banks, it is undeniable that possible stagflation would create a complex scenario for investors. In the bond sector, the prospect of further rate increases could have further negative effects on bond prices.

Stock markets, however, could be affected by less positive sentiment about economic growth globally. Of course, these are purely theoretical considerations, and it should not be forgotten that stock prices already discount future scenarios in advance. This is why, even in a stagflation scenario, the importance of portfolio diversification and having the support of a good financial advisor emerges, who can interpret possible scenarios and recommend the right amount of liquidity to hold in periods of uncertainty such as the current one.

Similar considerations should be made for real estate, an asset class that, like all so-called real assets, traditionally retains value (and protects wealth) during periods of high inflation. There remains, of course, the unknown about the mortgage market, which is the main driver of the brick market. Higher interest rates indeed mean more expensive mortgages and somewhat less affordable than before. The next few months will therefore give crucial insight into which path the real estate sector will also take.