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Recession appears to be knocking at the door again. Most economists, after a series of increases in the cost of doing business, consistently excessive inflation, stock market volatility, and a quiet financial boom, have now agreed that a slowdown is coming, although opinions vary on how harsh it should be. Some declare that a mild and rapid recession is about to occur, while others worry that we will face much harder times.
One topic that has been circulating quite a bit lately is the prospect that we may be heading towards a period of stagflation. This has only happened once before in the United States, in the lower coasts in the 1970s, and it's not a pleasant adventure.
Key findings
- Stagflation is a stagnant financial system combined with excessive inflation.
- Stagflation is equivalent to a killer aggregate and can result in a financial crisis where bills and housing costs continue to rise.
- These types of financial crises are sometimes caused by large supply shocks and direct monetary policy, and end in recessions that are longer than average because there is no definitive cure.
- Generally, when a recession occurs, activity rates are reduced to stimulate economic activity. But central banks cannot, in reality, do this when inflation is rising.
- Some economists fear that the US financial system is heading towards stagflation for the first time since the 1970s.
What is stagflation?
The term stagflation is a combination of "stagnant" and "inflation." It describes a period of low to nonexistent financial growth coupled with impulsively increasing spending.
What is the difference between stagflation and recession?
It is often observed that a recession is underway as soon as there are two consecutive quarters of low economic growth. Stagflation, however, is much more open to interpretation, mainly because it is rarer.
A stagnant economic climate is not necessarily a climate of recession. The word stagnant implies slow and deficient growth, which can mean a full-blown recession or simply very vulnerable growth. The degree of inflation is also not defined, although we assume it should be at least above the 2% limit established by the most relevant banks in leading economies.
Another fundamental change is the timing and frequency. Recessions are considered a traditional part of the financial cycle, occurring fairly regularly and historically lasting just under a year. Stagflation, on the other hand, is uncommon and, when it rears its grotesque head, tends to linger. These styles of economic crises are difficult to defeat because the common tactic of reducing borrowing costs to stimulate growth is off the table.
Continuously high inflation is linked to economic growth and can be curbed by raising interest rates. Stagflation, on the other hand, is a distinct type of beast that is more difficult to tame.
What causes stagflation?
Based on the few examples we have witnessed so far, it is often agreed that the main reason for stagflation is an incredible supply shock. If, even then, the supply of food, oil, or anything else essential is disrupted and is no longer able to meet demand, things tend to spiral out of control. Typically, the condition is exacerbated by poor financial policies.
Supply shocks send prices on an upward surge, hurting organizations, consumer funds, and the financial boom. And when valuable banks respond, as they always do, to economic turmoil by ensuring money is cheap to borrow, they essentially fuel the flames of inflation, stimulating demand and further increasing rates.
The term stagflation was first used in 1965 by British meat presser Iain Macleod.
background of stagflation
To date, the United States has experienced only one significant instance of stagflation: in the 1970s.
1970s
Throughout the 1970s, the supply of oil fell dramatically and prices soared, first because of an embargo resulting from a war between Israel and the Arab states, and second because of the Islamic revolution in Iran. These movements, along with the easy fiscal cover that the major American bank sought to boost employment, led inflation into an out-of-control spiral and threw the economy into disarray.
It took very high hobby rates and a severe recession to restore order. And, as you can probably imagine, the stock market became overwhelmed.
Will stagflation return in 2023?
Nowadays, there is a fear that a similar circumstance could happen again. Inflation is extraordinarily excessive, and the economic system is clearly no longer functioning precisely on all cylinders.
How did we find ourselves in this situation? A mix of exciting and random components is certainly responsible. First, there was the COVID-19 pandemic, which resulted in a lockdown and a construction standstill followed by a surge in demand once restrictions were lifted. Then Russia invaded Ukraine, causing even more supply chain disruptions and leading to soaring oil expenses. And on top of everything else, each of these destabilizing events occurred when hobby rates were traditionally low and money was extremely cheap to borrow.
Other factors are emerging that may contribute to today's stagflation, including high debt, alternative protectionist policies, an aging population, geopolitical tensions, climate change, and cyber warfare. And some of them are not going away, meaning that stagflation may be here to stay for a long time.
Technically, the financial system is not in recession. Although most economists now agree that the only missing factor, higher unemployment, could quickly become a reality as higher debt service expenses tempt companies to lay off staff. In practice, many Americans are out of work and a gradual financial boom is occurring alongside excessive inflation and stagflation.
So, are we doomed? Not necessarily now. Economist Nouriel Roubini is convinced that the attempt by the Federal Reserve and several central banks to contain inflation will lead to a hard touchdown and a stagflationary debt disaster. His opinion is not shared by everyone, however. Stanford economist John Cochrane, for example, hopes that the potential inflation will disappear and the possibility of stagflation can be avoided.
At this point, much depends on the effectiveness of pastime rate increases in reducing demand and whether major supply shocks will also be resolved immediately. If inflation does not subside soon, the US and global economies may be facing more than just a daily recession.
When the economy is heading towards recession, the relevant banks ease monetary conditions. They cannot do that now, however, because inflation is high, and that is undoubtedly very worrying.
Why is stagflation bad for the economic climate?
Stagflation is a combination of three negative factors: gradual economic growth, higher-than-normal unemployment, and high housing costs. Whichever way you look at it, this situation will be painful.
Normally, in order for agencies to hire again and for the financial system to function properly, the prices of entertainment options are reduced. However, when inflation is looming, this move is dangerous;
This is not only an incredibly uncomfortable environment to live in, but also a rather problematic one for governments to fix. Without an easy solution, stagflation could drag on for years, causing great damage to the economic climate.
Stagflation can make a daily recession seem like a walk in the park. Prices rise instead of stabilizing or falling, and the equipment continually used to fix the economy is ineffective, meaning that this pain can also last a long time.
If we still find ourselves in this situation, the consequences could be catastrophic. As Roubini points out, the deepest public debts are much larger than in the past, accounting for approximately 350% of the international gross domestic product (GDP) because loan prices have been low for years. Now that things are changing here, a storm is brewing, with higher loan prices threatening to drive leveraged households, agencies, economic associations, and even governments into bankruptcy and default.
If events unfold as Roubini predicts, we could soon find ourselves in an unprecedented economic crisis, with the stagflation of the 1970s potentially accompanied by a debt collapse similar to the 2008 recession. The mere idea of a combination of these recessions, two of the worst on the list, is enough to send shivers down your spine, Roubini writes.
Is stagflation worse than a recession?
Okay. Stagflation is definitely like a recession with the added headache of increased expenses and debt burdens for operators. And since there's no definitive cure, it's harder to overcome and can be a long-lasting problem.
Is it a good idea to buy a house during stagflation?
That's a difficult question. If rates continue to rise, it might make sense to buy now instead of waiting. However, mediocre economic growth could also weigh on property rates, while high activity rates, crucial for combating inflation, will suggest less favorable lending conditions. Much depends on individual cases, what cost can be offered, and how long the inflation spike persists, which is now anyone's gamble.
What investments are most suitable during stagflation?
Currently, many traditional asset classes do not perform well in this type of environment. The best performers would likely be those with inflation-hedging qualities, such as inflation-indexed bonds, gold, and perhaps specific real estate.
The bottom line
Many people may have experienced what it's like to live in a stagnant economic climate, but may not be familiar with stagflation. Judging by their standards and accounts from the 1970s, it might be better for everyone if this method continued.
Imagine living through a financial crisis where people are losing their jobs while expenses and the cost of living continue to rise. Stagnant growth and high inflation are a deadly combination that can cause significant damage to a financial system and leave lasting scars.
