PERSPECTIVE3-5 min to read

Regime shift: time to prioritise inflation over growth?

It’s unfamiliar territory for some, but the old trade-off between inflation and growth has returned.



Azad Zangana
Senior European Economist and Strategist

Central banks are currently raising interest rates to bring inflation to heel. If they succeed, which we believe they will, it seems very likely that the cost of doing so will be an economic slowdown, and even recession in some instances.

This old trade-off between inflation and growth may be unfamiliar territory for some, as it represents a clear break with the economic regime of the previous 15 years. But the trade-off is now feeling very real.

The “NICE” period when central banks had time on their hands

Russia’s invasion of Ukraine will, we suspect, transpire to be a watershed moment in the journey back in time to when central banks had to be far more focused on controlling inflation. In the past they had to be much more ready to raise interest rates to achieve price stability as their old inflationary foe was always lurking just out of sight.

Similarly, they now may need to be more proactive than any time since the advent of the “NICE” (Non-Inflationary Consistently Expansionary) era, which began in the late 1990s. This era was in large part driven by globalisation and marked the start of a near three-decade period of relative calm and prosperity.

We don’t believe we’re going back to the inflation prone 1970s and 1980s which we experienced prior to the NICE era. At the very least, however, it seems interest rates are likely to be higher over the next five to 10 years than they have been over the last 10 to 15 years, being the required trade-off to keep inflation in check.

New economic regime and demographic vulnerabilities

Problematic re-openings following the initial pandemic lockdowns of 2020/21 gave us the first inklings of a possible break in regime.

Images of container ships unable to leave port in Asia - some of them carrying vital PPE equipment for the fight against Covid-19 in the West – were a window on what might happen. They showed what could occur should the globalised model of extended supply chains – and the existing world economic order – be seriously threatened.

Certainly the ensuing period of intense goods price inflation contrasted vividly with the previous three decades when globalisation had contributed to a long-term decline in prices (see chart, below).

Dividend of globalisation

More recently, we’re seeing what an increasingly protectionist world may mean for inflation.

Services inflation in developed economies is being driven by wages as a result of labour shortages exacerbated by the pandemic, which encouraged many into retirement, or economic inactivity due to ill health.

Services sector inflation, will, we suspect, eventually subside as all the major central banks get on top of the problem.

But the new economic regime has created vulnerabilities.

For instance, there are fewer options to manage the longer-term trend of falling labour participation rates as populations age. Boosting labour supply by relaxing immigration controls seems unlikely in post-Brexit UK, post-Trump US, and increasingly in Europe, for instance.

Diminishing globalisation dividend alters central bank calculus

Flexible labour markets helped to underwrite the “NICE” period between the mid 1990s and early 2000s, at which time globalisation was in full flight and a Bill Clinton-led US administration cheered China’s accession to the World Trade Organization.

Central banks had time on their hands. Low and stable inflation helped foster the right conditions for companies to invest and expand with confidence, while consumers, businesses and government all benefited as interest rates remained in check.

It’s no accident that one of the dividends of globalisation was a long period of very low unemployment, in marked contrast to the experience of the inflation prone 1970s and 1980s.

Price stability, however, morphed into “lowflation” after the 2007/08 Global Financial Crisis, when there was the constant threat of deflation (falling prices) in the West – arguably as corrosive for confidence and growth as high inflation.

Interest rates were cut to zero to stimulate flagging growth and it became necessary for central banks to use new methods to maximise employment (one of the other mandates of many central banks, aside from price stability).

Perhaps the most notable of these methods was quantitative easing (QE), which involved buying up vast quantities of bonds to suppress interest rates and stimulate borrowing.

These policies worked until it became apparent after Russia’s invasion of Ukraine that the world had changed. It had moved into a more permanent state of supply shortages and more frequent price increases and a new economic regime.

That, however, did not stop central bankers initially believing inflation would subside by itself without the need for higher interest rates.

It would be a case of waiting for the external shocks caused by the pandemic and then the war to wash through the system, so they thought.

But as inflation spread to service sectors, it became engrained in domestic economies. It could not just be characterised as an external phenomenon; central bankers realised there would again indeed be a cost for taming inflation.

Decarbonisation – adding to inflationary pressures

Interest rates would need to rise enough to induce an economic slowdown, even a recession, to curtail wage growth which was driving these trends.

The alternative was to risk an unhinging of inflation expectations, as occurred in the 1970s and 1980s, when workers were demanding and achieving much higher pay increases, even after inflation had begun to moderate.

The loss of price stability resulted in “wage price spirals” as the cost of pay increases had to be passed on to consumers in the form of price rises, and so the cycle continued. It took multiple rounds of interest rate rises, which even took rates into the double-digits, before prices eventually returned to lower, more normal levels.

At times during this period we saw the worst possible growth-inflation trade-off occur, with inflation still positive as economies were contracting, a set of circumstances known as “stagflation”.

While such worst-case scenarios appear to have been avoided for now, it seems we’re unlikely to return to another “NICE” period either.

Labour shortages and wage pressures will likely to persist in into the medium term – remember there are still almost two job vacancies for every unemployed worker in the US (see chart, below).

Vacancies versus unemployed

Additionally, the energy security issues highlighted by the Russia-Ukraine war have added urgency to efforts to transition to green economies in what will be a very expensive process of decarbonisation.

More widely, the Ukraine war has opened up further fault lines in the world economic order, possibly creating the circumstances which could lead to an active unpicking of globalisation, in other words deglobalisation.

Deglobalisation – another potential inflationary force

Since the war we’ve seen how countries which might previously have sided with the US rather than China take a more neutral stance, adding to the risks of a decoupling in the world’s two largest economies.

This is prompting multi-national companies in the West to consider reshoring, or nearshoring overseas production as well as redirect investment into “friendly” lower risk countries, so-called “friendshoring”.

These trends are another threat to a system already tested by Brexit, tariffs left over from the trade wars of the Trump presidency (added to by Biden) and the pandemic.

They will ultimately be inflationary if concerns over supply chain resilience and reliability rather than economic efficiency alone come to drive future decision making in the new regime.

The trade-off between inflation and growth has returned and central banks are going to have to prioritise restoring price stability in a clear break with the economic regime of the previous 15 years.

Central banks have a lot less time on their hands these days.


Azad Zangana
Senior European Economist and Strategist


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