What Is Stagflation?
It is especially difficult to curb stagflation, since both inflation and unemployment rise
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Stagflation is a word feared by most central banks. This term refers to a toxic combination of rising unemployment and negative gross domestic product GDP which creates economic stagnation. And, unlike what happens in a recession, where businesses fold, manufacturing output declines, and demand, and thus, prices, fall, stagflationary environments also come with increased prices and high levels of inflation, creating an especially difficult problem to solve.
While central banks have some tools at their disposal to combat stagflation—or better still, to prevent their economy from becoming mired in it altogether—there are some stocks that outperform even through such harsh conditions. We’ll get more into them below.
How Does Stagflation Occur? What Happens to the Economy?
The phrase “stagflation” is a creative mix of “stagnation” and “inflation” first uttered by British politician Ian Macleod in the 1960s. Students of economic theory had long thought this occurrence improbable, mainly because unemployment and inflation tend to move inversely: When unemployment is high, prices usually decline because demand lessens, and vice versa.
But it can and does happen.
Stagflation Example
Stagflation occurred in the United States in the 1970s as a result of rising unemployment, slow economic growth, and an oil crisis. In fact, it could be said that much of the 1970s and early 1980s were a time of recession. Unrest in the Middle East had led the United States to supply arms to Israel, which angered the Arab nations of OPEC, the Organization of Oil Exporting Countries. OPEC controlled more than half of the world’s oil supply, and as a result of the intervention, they punished the U.S. as well as other nations by imposing an embargo, effectively banning the export of oil exports as well as limiting oil production.
The oil embargo caused severe supply shortages, and prices skyrocketed on demand. The embargo was not lifted until 1974, when the United States convinced Israel to withdraw troops from the Sinai Peninsula, although the Iranian Revolution in 1979 later created further disruptions in the oil supply all over again.
Economic theorists, particularly those who followed the teachings of John Maynard Keys, believed that in this scenario, rising oil prices should actually drive economic growth. But this did not happen. The Federal Reserve tried many ways to combat stagflation, but critics believe that little helped because there was excess liquidity in the markets, basically allowing room for prices to continue to rise. It took until 1979, when Fed Chair Paul Volcker increased interest rates to double digits, to quell the rampant inflation.
What Are Some Causes of Stagflation?
Sluggish economic growth and rising unemployment set the scene for stagflation, but it takes an extra ingredient, such as a supply shock, to fan the flames. Supply shocks are unexpected events that cause major disruptions in a supply chain, like a war, a natural disaster, or, in contemporary times, the global COVID-19 pandemic. The Federal Reserve even published papers detailing how it recalibrated fiscal policy in response to this supply shock, by injecting liquidity into the markets and lowering interest rates.
What Are Some Effects of Stagflation?
No one should be surprised to hear that living through stagflation is a pretty miserable experience. In fact, economists even created Misery Index as a way to measure the level of distress an average person feels economically. This rate is calculated by adding the seasonally adjusted employment rate to the inflation rate. The highest the index has measured was during Ronald Reagan’s first term.
The Misery Index is the sum of the employment rate plus the rate of inflation
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How Do You Combat Stagflation? Why Is It So Hard to Fix?
Central banks usually have to fight inflation or slow growth, not both at the same time. When this happens, they typically have to choose the greater evil to focus on first. After the first wave of the COVID-19 pandemic, the Federal Reserve began a series of quantitative easing measures designed to increase liquidity and spur growth, mainly through increased credit and lending. Now that it seems that inflation is here to stay, many believe the Fed will be raising interest rates in order to attack it—at the temporary expense of economic growth.
How Do You Invest When There’s Stagflation? Which Stocks Do Well?
Usually, the stocks which benefit from inflation do well in stagflationary environments, such as value stocks, whose share prices are currently trading lower than their true worth, or intrinsic value. Investors use metrics like price-to-earnings ratios (PE Ratios) to determine a stock’s relative value.
How Is Stagflation Different from Other Inflationary Periods?
We’ve put together a glossary of key terms:
Glossary of Inflation-Related Terms
Deflation, the opposite of inflation, happens when the prices of goods and services decline, usually due to changes in monetary supply. On the upside, consumer purchasing power increases, i.e., they “get more for their dollar,” although it must also be noted that deflation usually signals a slowdown in the economy.Disinflation, not to be confused with deflation, simply means that inflation is increasing at a slower rate than previously expected. For example, if the monthly CPI was measured at a 4.2% annual rate in June and 3% in July, prices disinflated by 1.2%—yet are still increasing at a 3% annual rate.Hyperinflation is inflation that is off the charts high and still accelerating. We are talking rates of 1,000%+. Hyperinflation has crippling effects on an economy and can crash a currency. In Hungary after World War II, the rate of hyperinflation was so bad the government needed to print a 100 quintillion dollar bill, making it the highest denomination ever issued.Stagflation is a toxic combination of high inflation, high unemployment, and little to no economic growth.
Are We Experiencing Stagflation?
Job reports are missing expectations, yet stocks are rising, and bond prices falling. TheStreet’s Jim Collins blames the Fed for the market’s current confusion, saying everything has to do with the “weird cult of Janet and Jerome.” Find out what he thinks will happen next.
