Is stagflation a serious market risk?
Stagflation: This ghoul from the era of the shag mat and disco balls.
This is something that has not been seriously discussed in business circles since the late 1970s. But today, as inflation hits decades-long highs and companies say the bottom line could end. Apart from being disappointing in the coming quarters due to rising costs of labor and materials, stagflation is again a real cause for concern.
The question is: should it be?
What exactly is stagflation?
First of all: stagflation is the combination of high inflation and sluggish growth. It is the unholy union of stagnation and inflation, and it is the definition of economic misery.
In fact, it was during the stagflationary 1970s that economist Arthur Okun created the “Misery Index”: the simple sum of the inflation rate of consumer prices and the unemployment rate.
This is not the way the economy is supposed to work. Inflation is supposed to be the price to pay for growth, and high unemployment or other measures of stagnation are the trade-offs we have to make to keep inflation low.
Having both at the same time is a nightmare because whatever you do to slow inflation, like the Federal Reserve by raising interest rates, making stagnation worse … and whatever you do to stimulate growth makes growth worse. inflation.
What are the causes of stagflation?
There are similarities between the 1970s and today, but there are also some important differences. But to understand this, you must first understand that there are two types of inflation: pulling demand and pushing costs.
Demand-driven inflation typically occurs when the Fed increases money supply or Congress cuts taxes. This is the inflation you get from excessive demand. When we all buy at the same time, prices go up. If there is “good inflation”, it would be this.
Cost inflation is another story. This is what you get when the supply is limited. Think about housing today or crude oil prices during the OPEC embargoes of the 1970s.
The causes of the stagflation of the 1970s were complicated. You’ve had demand-driven inflation due to the Fed’s dovish policy and government spending on new social programs and the Vietnam War. And you also had cost-driven inflation driven by the oil embargo and the general rise in commodity prices. But we also had a major productivity problem. By the 1970s, the industrial model in place since the New Deal had become obsolete and the United States was in the early stages of deindustrialization due to lighter competition from Japan and elsewhere.
Things turned out badly. But then they got better.
President Jimmy Carter launched and Ronald Reagan massively accelerated the trend towards deregulation and privatization, which boosted productivity. The country has evolved into a productive service economy. OPEC has lost its grip on the energy market. The Fed has improved its policy. And we no longer had to pay for the Vietnam War. Stagflation gave way to higher growth and lower inflation.
Today we also have high demand-driven inflation due to low interest rates and COVID relief efforts that are putting money in America’s pockets and, for a while, causing workers to stay. at their home. Getting Americans back to work has been a challenge and has led to higher wages.
Meanwhile, we have a lot of cost inflation due to the post-COVID supply chain being a wreck. Everything from lumber to microchips is scarce, causing prices to skyrocket.
Why stagflation won’t last
Supply chain disruptions will not last forever. It could very well be a lean Christmas, but eventually the supply chains will be “fixed”. Prices might not go down tomorrow, but as supplies return to something that looks like normal, they will moderate.
Meanwhile, we live in a world awash with energy. OPEC does not have the power to control energy prices on a whim like it did in the 1970s. When prices get high enough, new supply floods the market from American shale producers and others who are not members of OPEC. And we haven’t even mentioned the boom in solar, wind and other renewable energies.
And on the job side, American workers should take advantage of their windfall today because it won’t last. Automation is replacing labor at the fastest pace since the Industrial Revolution, and the current labor shortage will only force companies to invest even more in automation to speed up the process.
This does not mean that we live in a “fair” Goldilocks economy. It is entirely possible that we will see a recession next year if the great post-COVID recovery starts to falter.
But the risk of lingering stagflation is minor, as is (hopefully) the return of earth tones and horseshoe whiskers.