January 27

What is Stagflation and What Does it Mean For Your Investments?

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Stagflation is an economic phenomenon characterized by rising prices together with a stagnant or shrinking economy. Economically, stagflation represents the “worst of both worlds.” Retirees and consumers get hammered by rising prices. Businesses get squeezed by rising costs for doing business, and workers have a hard time finding employment. The U.S. economy experienced a long, painful period of stagflation between about 1973 and 1981.

The ill effects of stagflation were exacerbated at that time by the Arab oil embargo, which caused widespread shortages across the U.S. However, readers should also note that the period of stagflation began shortly after President Nixon took dollar off of the Gold Standard, effectively removing an important check on the growth of the money supply.

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Origin of the Term “Stagflation”

The term stagflation can be traced back to a 1965 speech before the British Parliament by MP Iain Macleod:

"We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation and history in modern terms is indeed being made."
Iain Norman Macleod

Iain Macleod

Image credit Wikipedia

MP McCloud then went on to lament efforts by the British government to conceal price increase in important consumer goods and services through providing subsidies on coal and transportation.

"London bus and train fares were to rise, so the Government provided a £51½ million subsidy, which runs out at the end of the year—but what then? Coal prices were to rise, so the Government gave a £15 million subsidy, which runs out in April—but what then? I ask, because all that is happening is that one is building a dam that is bound to burst in an economy where incomes are swiftly rising while production is completely stagnant."

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Fast forward to today:

Inflation has heated up significantly. Over the past year, consumer prices rose more than 7% - the worst level of inflation in a generation.  

Normally, inflation is associated with a money supply that is growing too fast for the underlying economy to support. Governments, central banks, or both, want the benefits of full employment and generally happy voters. And they’re happy to increase government spending and encourage banks to lend money to make it happen.

Dr. Milton Friedman argued that stagflation is primarily a monetary phenomenon.

When the amount of money flooding into an economy outstrips production, all that liquidity has to go somewhere. Too much money is chasing after too few goods and services. Dollars are less scarce than goods. And prices have nowhere to go but up.

Governments eventually borrow too much and spend too much. Central banks print too much money, and make it easy for banks to lend even more money, flooding the economy with liquidity. Unlike the printing press, real-world production is limited by the scarcity of actual, hard resources. And so producers can’t keep up with the increasing money supply.

Normally, Central banks and policymakers deal with spiking inflation by ‘tapping the brakes’ on the economy. In the U.S., the Federal Reserve Open Market Committee does this by increasing interest rates on short-term loans to banks, and by constricting the money supply.

The problem today is that the economy is still trying to find its footing. Businesses and consumers are still reeling from the COVID shutdowns, and from the disruptive effects of the Omicron Variant.

Economic growth was strong in the second quarter, with the Bureau of Economic Analysis estimating economic growth at an annualized 6.7% between April and June.

But the economy slowed sharply between July and September, to an annualized growth rate of 2.3%.

Congress and the Federal Reserve (mostly) staved off a deflationary spiral by flooding the economy with liquidity, in the form of stimulus spending, lending, crediting banks with money to lend (this is what they call ‘printing money), and by holding interest rates at rock bottom.

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Is Another Recession on the Horizon?

If there’s another recession, The Federal Reserve has nearly exhausted its capacity to provide further stimulus. Interest rates are already near historic lows, and have been for years.

Economists know how to address inflation. And they know how to address recessions, or periods of economic contraction.

But they don’t know how to deal with both happening at the same time. 

Related video below: Steve Forbes on Fox Business - Here's how Biden can avoid stagflation.

After last summer’s strong period of economic growth, Federal Reserve already signaled that it plans to start increasing interest rates starting in March in order to tamp down inflation. This slows down lending and reduces the amount of money flowing through the economy.

But it also tends to hurt economic growth. Higher interest rates mean less lending. It means fewer purchases of high-ticket items. Which causes workers who make and sell high-ticket items to get laid off. It causes businesses to stop hiring. And workers must reduce their own consumption. This reduces demand for products and services, causing further layoffs as the spiral deepens.

The policy fix for inflation makes the jobs situation worse.

The policy fix for recessions makes inflation worse.

Keynesian economists were befuddled. They had always responded to economic contractions by goosing the money supply. This usually quickly boosted aggregate demand, and caused factories and retailers to crank up again to meet the demand, and put people back to work.

Mortgage lenders had to demand higher and higher rates, in order to protect themselves against further declines in the dollar. No one wants to lend a dollar only to get paid back in dollars worth half of what they were when they issued the loan.

So as the 1970s dragged on and stagflation got worse and worse, it was clear that the traditional Keynesian approach just wasn’t working. Instead, workers responded by increasingly demanding higher pay to compensate not just for past inflation, but for expected higher inflation rates in the future.

Likewise, producers hiked prices on forward contracts, again to hedge against expected future inflation.

The more liquidity they pumped into the economy, the worse this problem became. Price increases continued to absorb the excess stimulus Congress and the Fed were forcing into the system and erasing any theoretical gains in real production. 

Worse, the U.S. government initially attempted to mask the real problem of rising prices by imposing price caps on fuel. But instead, this just deepened the shortages even more.

Related: When should you start taking social security?

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Breaking Inflation. But at a Cost.

In 1981, Federal Reserve chairman Paul Volker – a Carter appointee – increased the fed funds rate, looking to restrict the money supply and knock down inflation, which had reached double digits by the time Ronald Reagan took office in January of that year.

The result was a sharp, painful recession. Hundreds of thousands of jobs were lost. The news frequently featured segments showing family losing land they had farmed for generations to foreclosure.  Employment was down. Suicides were up.

 But despite the pain – and largely because of it – The Volker Fed did manage to tame inflation and put monetary policy on a more solid footing.

Is Stagflation Inevitable?

No. While we’ve had some short-term stagflation in the form of price increases combined with slower growth, that growth hasn’t quite been “stagnant.” The economy continues to grow. Unemployment is relatively low. In fact, employers in many industries are scrambling to attract talent in an extremely tight labor market.

The low unemployment gives the Federal Reserve a little more flexibility in using interest rate increases and tightening the money supply to take the edge off of inflation.

Furthermore, while we’ve seen oil price increases, they aren’t due to an outside embargo. Instead, they’re due to global economies opening up after COVID shutdowns, increasing demand for energy.

Many of these issues should resolve as the COVID crisis abates, vaccination rates rise, workers get back to work, and supply chain issues get worked out of the system.

Nevertheless, U.S. stocks reeled with the Federal Reserve’s announcement that they anticipate rising rates beginning in March. The S&P 500 has posted a 9.2% decline over the last month, as the expectation of rising interest rates gets baked into the system.

In the short run, increasing interest rates from a more hawkish Fed may force stocks to take another haircut. Shorter-term bonds – already priced near all-time highs – will see yields rise and prices fall. However, if the Federal Reserve is successful in establishing its credibility in its effort to protect the integrity of the dollar, we could see the yield curve steepen, as long-term interest rates fall. This would reflect the notion that future issuers of long-term debt don’t have to include as big an inflation hedge as they do today.

Inflation, Stagflation, and Your Investments

Nonetheless, the fight against inflation and stagflation could cause substantial volatility in both the stock market and bond market over the course of the next year.  Longer-term bonds are especially risky, as a small change in the prevailing interest rate can cause a big swing in bond prices.

Gold and precious metals may be a useful diversifier against stock and bond market volatility. While a tightening monetary policy and a serious fight against inflation is usually better for the dollar than it is for gold, the metal is not directly linked to either of the other asset classes.

This is why gold, silver, palladium, and platinum have a natural place in most retirement portfolios. Long-term, inflationary pressures are still strong, as Congress has demonstrated little will to rein in spending and control deficits. Stocks appear to be well over their skis, with many big names massively overvalued thanks to years of quantitative easing.

As always, diversification is the watchword of the day. Own some gold, and spread your wealth among many different types of assets. Request a free gold investor guide from Goldco Precious Metals below or choose from our list of top recommended gold companies here.

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About the author 

Ilir Salihi

Ilir is passionate about personal finance, investing, and digital marketing. He's written about precious metals and cryptocurrencies since 2013. When he's not publishing new content, he's spending time at home in Washington, D.C. with his family.

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