The debate about stagflation has intensified over the past few months due to the weaker-than-expected job growth, disappointing economic data coupled with rises in the CPI have some believing stagflation is around the corner. Are the recent gains in the CPI temporary and the bottlenecks in the supply chains also transitory?
What is Stagflation?
A British politician, Iain Macleod, who later became Chancellor of Exchequer in 1970, first coined the phrase stagflation in a speech to Parliament in 1965. Stagflation is an economic condition characterized by slow economic growth (i.e., stagnation), persistent inflation (i.e., rising prices), and high unemployment.
What Causes Stagflation?
High oil prices and rising commodity prices can lead to stagflation. The supply-side shock to the economy results in higher business costs (i.e., transport costs more expensive, raw materials increase, etc.), which causes a higher inflation rate and lower GDP.
Powerful trade unions and higher wages can lead to higher inflation.
Lower or declining worker’s productivity can lead to inefficiencies, higher costs, and falling outputs, resulting in lower GDP.
A rise in structural unemployment can lead to a stagnant economy and lower GDP.
Why is stagflation such a problem?
An economy that suffers from stagflation tends to experience a period of relatively high unemployment and prices. The combined effects of the above economic conditions make it difficult for consumers to purchase goods and services. Also, under this economic environment, it is challenging to find new jobs and new economic opportunities. Stagflation can lead to devastating effects on businesses in almost every industry.
How can stagflation be prevented?
There are no quick solutions once stagflation develops. Fixes for stagflation are also highly unpopular in the U.S. It often requires an aggressive monetary policy (Fed hiking interest rates) to reduce inflationary pressures. Privatization or price controls to stabilize the out-of-control rise in energy prices. If higher wages are the cause of inflation, the government will curb wage increases. Also, reducing the dependency on oil can help the economy be less vulnerable to any supply-side shock from rising energy prices, preventing the onset of stagflation.
When was the last period of U.S. Stagflation?
Stagflation remains a rare economic phenomenon. Stagflation last occurred in the U.S. during the 1970s when oil prices quadrupled from the 1973 oil embargo. Although inflation tripled in 1973, rising from 3.6% in January to 8.7% in January 1973 and then moving toward a range between 10% and 12% from February 1974 to April 1975, it was a combination of conflicting fiscal and monetary policies that created a perfect economic storm.
There were two periods of rising inflation and slow economic growth during the 1970s – one between 1973 and 1975, when rising foods, rising energy prices, GDP contraction, and the end of the Nixon wage-price controls programs led to stagflation. The second spike in inflation and GDP contraction occurred from 1978 to 1980, due primarily to food supply limitations.
Most recently, classic signs of stagflation developed during 2008, following the rise in the price of oil and the start of the global recession. In 2011, people became increasingly concerned about stagflation again. Many were concerned about the Fed’s easy monetary policies used to rescue the economy from the 2007-2009 global financial crisis that would lead to inflation in a weak economy. However, the Fed and central banks' concerted efforts of injecting global liquidity into the global financial system prevented a far worse economic condition, a deflation cycle.
Is the U.S. economy entering into another Stagflation cycle?
There are similarities developing today that compare to that of the 1970s. For one, the Fed is again deploying easy monetary policies coupled with stimulative fiscal policies. Two, the 1973 oil embargo triggered rising inflation. Today, supply chain issues and bottlenecks as the result of the Covid-19 pandemic, including constraints on oil and gas, shipping, semiconductors, etc. may lead to rising inflation. Three, domestic and political uncertainties occurred under President Nixon's administration. Today, there is also domestic and political turmoil developing under President Biden's administration. There is also another greater international crisis developing with China.
Although some believe the U.S. is moving toward another period of stagflation, many others suspect the unusual conditions that created stagflation during the 1970s are unlikely to reoccur. The reasons are as follows: (1) Fed no longer deploy the same stop-go monetary policies as in the past. Fed Chairman Powell utilizes a more transparent and consistent Fed messaging strategy. (2) The U.S. Dollar is no longer on the gold standard as this event was a once-in-a-lifetime situation. (3) It is unlikely the Fed or Congress would implement the same wage-price controls that constrained supply as in the prior period.
Attached below are charts showing the Dow Jones Industrial Average (INDU) during the 1970s and today.