In 1965, the British economy faced a two-pronged assault: weak growth coupled with rapidly rising consumer prices. A British Parliamentarian described this paradox by mashing together Ã¢â‚¬Å“stagnantÃ¢â‚¬Â and Ã¢â‚¬Å“inflationÃ¢â‚¬Â to come up with Ã¢â‚¬Å“stagflationÃ¢â‚¬Â. The term immediately became a fixture in the financial lexicon and has been striking fear in the hearts of government officials ever since.
Stagflation is the most terrifying of economic circumstances because it is the most difficult condition to combat. On the one hand you have a slowing economy which calls for an easing of monetary policy to encourage spending. On the other hand, you have inflation spurred on by rapidly rising prices. To deal with inflation, the standard approach is to tighten monetary policy by raising rates to discourage spending. This inherent contradiction makes it difficult to implement an effective policy against stagflation.
Ã¢â‚¬Å“We now have the worst of both worlds Ã¢â‚¬â€œ not just inflation on the one side or stagnation on the other. We have sort of Ã¢â‚¬ËœstagflationÃ¢â‚¬â„¢ situation.Ã¢â‚¬Â
British Member of Parliament
How is it possible for an economy to be in such a conflicting state? Certainly this is not a common occurrence, but given the right conditions and an event that causes an extraordinary shock to the economy, both conditions may exist simultaneously. Some analysts suggest we are close to experiencing those conditions now.
Disaster lays the groundwork
The last case of stagflation in the U.S. happened in the early 1970s. With the economy drifting listlessly, a severe shock was applied in the form of an oil shortage imposed by OPECÃ¢â‚¬â„¢s infamous embargo in 1973 Ã¢â‚¬â€œ retaliation against the U.S. for supporting the Israeli military during the Yom Kippur war. Oil prices jumped by 50 percent overnight and the disruption in supply caused even more damage. Gasoline service stations throughout Europe and North America were forced to close due to a lack of product.
Once again, unrest in the Middle East is pushing crude prices higher and causing concern over supplies. In the past six months, oil has surged by more than 25 percent and, at press time, is hovering just above $100 a barrel. This is considerably less than the $145 that crude hit during the summer of 2008. This time, however, few expect the price to retreat and $100 a barrel is now seen by many as the new floor for crude.
The Ã¢â‚¬Å“Out of GasÃ¢â‚¬Â signs have not yet been pulled out of the closet. But as violence spreads through the Middle East, there is an unmistakable sense of dÃƒÂ©jÃƒÂ vu.
We are also dealing with a Ã¢â‚¬Å“Black SwanÃ¢â‚¬Â event in the form of the tragic earthquake and subsequent tsunami in Japan. At this point, the full extent of the damage is still not clear, but just from a cost perspective, it is easily in the hundreds of billions. Global equity markets have been in a straight-line decline since the news broke and no one knows with certainty when the losses will be recovered.
Prices on the rise
With respect to consumer prices, it appears the other half of the stagflation equation is also forming. According to the U.S. Labor DepartmentÃ¢â‚¬â„¢s latest Producer Price Index report, food costs jumped 3.9 percent in February. This is the largest single-month increase since November 1974, when consumer-level food prices rose 4.2 percent. The cost of meat and dairy products increased significantly in February, but a full seventy percent of the PPI hike can be attributed to a massive increase of 48.7 percent in the cost of fresh and dry vegetables.
The Labor Department places the blame for the jump in food prices squarely on the sharp rise in energy costs and the diesel fuel required to grow, harvest, and transport the goods that find their way to the consumer table. Since the beginning of the year, gasoline prices have gained about forty cents a gallon and diesel has increased even more.
Growing unrest in the Middle East means a likelihood of even sharper increases in the cost of crude and, potentially, supply disruptions. OPEC has said it will attempt to make up any shortfalls, but production capacities are close to maximum already and any significant disruptions could result in a cut in supply.
Time will tell if these conditions mean the U.S. economy will fall into a full-scale case of stagflation. Keep your fingers crossed because those of us who survived the last instance of stagflation can tell you, the cure is just as painful as the ailment. Back then, Federal Reserve Chair Paul Volker tackled the inflation component by raising the federal funds rate from an average of 11.2 percent in 1979, to 20 percent by June 1981. This pushed the prime rate to 21.5 percent.
As prices retreated in the face of the punishing rate hikes, the Fed slowly reduced rates to encourage the return of growth. For those with mortgages or business looking to borrow money to expand their operations, this was a difficult time indeed.
In the end, stagflation was conquered but at a tremendous sacrifice and no one Ã¢â‚¬â€œ especially todayÃ¢â‚¬â„¢s policy-makers Ã¢â‚¬â€œ wishes for a return engagement.
Originally published in American Banker
This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.