By Dragon's Rock, world's policymakers plot how to slay stagflation

© Reuters. FILE PHOTO: U.S. Treasury Secretary Janet Yellen poses for a family photo with Germany's Finance Minister Christian Lindner and President of the Deutsche Bundesbank Joachim Nagel as they welcome attendees of the G7 Summit in Koenigswinter, near Bonn, Germ

By Francesco Canepa

KOENIGSWINTER, Germany (Reuters) - The world's top central bankers and finance ministers gathering near Germany's Dragon's Rock on Thursday have their own beast to slay: stagflation.

The Group of Seven financial leaders are meeting as the war in Ukraine adds fuel to a surge in the cost of raw materials while new pandemic-related restrictions in China have slowed down global trade, raising the spectre of a sustained period of high inflation and economic stagnation.

"We will have to discuss what we can do together in our respective areas of responsibility to avoid stagflation scenarios," German finance minister Christian Lindner told reporters as leaders arrived for the two-day meeting.

The palatial hotel in Koenignswinter where the event is hosted overlooks the Drachenfels, or Dragon's Rock, where the hero of the medieval Nibelung legend, Siegfried, is supposed to have slain a dragon that lived in a mountain cave.

Every bit as lethal and intractable as a mythological monster, stagflation had no easy fix: stimulate the economy and prices will run away even faster, close the money taps and you will choke off economic growth.

After underestimating inflation for most of last year, most central bankers from the United States to Europe and Australia were now single-mindedly focused on curbing prices that have been rising at the fastest pace in decades.

The Federal Reserve, the world's most influential central bank due to the dollar's dominance on global financial markets, has pledged to raise interest rates as high as needed even if that could end up costing some people their jobs.

Even the European Central Bank, which had until recently all but ruled out rate hikes, was now moving towards the first increase in more than a decade - probably the first of several.

But finance ministers are worried that the economy would deteriorate further as sanctions against Russia make importing raw materials from oil to wheat more expensive - straining household budgets just as borrowing costs also rise.

"The economic outlook globally is challenging, and uncertain, and higher food and energy prices are having stagflationary effects, namely, depressing output and spending and raising inflation all around the world," U.S. Treasury secretary Janet Yellen said in Bonn on Wednesday.

She has argued that the United States should remove tariffs of up to 25% on some Chinese imports that are not strategic, such as bicycles, lawn mowers and T-shirts - a move that would make them cheaper for U.S. consumers and offering much-needed relief.

Other governments such as Italy's and Germany's have cut the tax on fuel while France has capped the price of natural gas and electricity to soften the economic impact of soaring energy costs.

Yellen had previously avoided mentioning "stagflation" - a term associated with 1970s inflation spikes and sluggish growth - when describing the U.S. economy, which has strong momentum from the COVID-19 recovery and strong labour market.

A generation ago, it took Fed's chair Paul Volcker a brutal series of rate hikes and a recession to break the back of inflation, ushering an era of stable prices and steadier economic growth.

Legendary hero Siegfried was also said to have gained near immortality after bathing in the dragon's blood.

But an economic bloodbath is what today's policymakers are still hoping to avoid.