Is The U.S. Economy Heading For Stagflation?

Is The U.s. Economy Heading For Stagflation?
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Stagflation is a period of stagnant economic growth accompanied by persistently high inflation and a sharp rise in unemployment.

While stagflation is quite rare—the U.S. has only experienced one sustained period of stagflation in recent history, in the 1970s—it’s become a more frequent topic of speculation.

In its June 2022 global economic forecast, the World Bank warned that the risk of stagflation has risen due to a “sharp slowdown” in global economic growth coinciding with a “steep” rise in the rate of inflation to multi-decade highs.

While it remains to be seen whether the U.S. economy is headed for another bout of stagflation, it’s important to contextualize what’s happening now with the prominent episode of stagflation in the 1970s.

What Is Stagflation?

The term stagflation combines the words “stagnant” and “inflation.” Its first use is attributed to a British politician in the 1960s.

The World Bank notes in its report that there’s no precise definition. Stagflation refers to an economy characterized by high inflation, low economic growth and high unemployment.

Typically, when prices are increasing rapidly, demand exceeds supply and the economy is growing—so-called demand-pull inflation—which means people have the income to spend more money on goods and services, says Rob Haworth, senior vice president and vice president senior investment strategist at U.S. Bank.

However, during periods of stagflation, those dynamics are flipped—there’s a lack of supply pushing prices higher, but consumers don’t have more money to spend, adds Haworth. “It’s a challenging time for consumers with prices rising but incomes flat or stagnant.”

Because bouts of stagflation are so rare, very unusual events must occur to create a backdrop whereby the economy is “dead in the water,” and there’s high inflation, notes Brad McMillan, chief investment officer at Commonwealth Financial Network.

“Stagflation seems to break the rules of how the economy is supposed to work,” says McMillan.

According to the National Bureau of Economic Research, the economy fluctuates between growing and contracting as part of the typical economic cycle—and, in fact, there have been seven recessions in the U.S. in the past 50 years.

A long-lasting surge in prices has been quite rare in modern history and until this year, the inflation rate hadn’t been above 5% for 6 months or more since the 1980s. Experts say that such periods of sustained, high inflation are most likely caused by either a global supply shock or poorly-guided economic policies.

Example of U.S. Stagflation

There is only one notable period of stagflation in recent history in the U.S.: the 1970s.

During the 1970s, the rate of inflation was already rising when a series of oil supply shocks caused by the Organization of Petroleum Exporting Countries (OPEC) oil embargoes resulted in oil prices tripling or even quadrupling very quickly.

Those supply shocks followed a period of accommodative monetary policy in which the Federal Reserve grew the money supply to encourage economic growth. Meanwhile, global economic growth slowed sharply in the 1970s—a decade marked by two different recessions in the U.S. and the lead-up to a third one that began in 1980.

What made the 1970s so unusual was that all the necessary characteristics were satisfied to constitute “true stagflation,” notes Eric Bond, a wealth advisor and founder of Bond Wealth Management.

In the decades since, there hasn’t been a time when those three factors—high inflation, slow economic growth, and a rapid rise in unemployment—occurred simultaneously and for a prolonged period.

Current Risk of Stagflation

While the U.S. has sidestepped another bout of stagflation since the 1970s, many people are now drawing parallels between that episode and the current dynamics in the economy.

Economist Larry Summers, a former Treasury Secretary, argued in a March 2022 op-ed in The Washington Post that the Federal Reserve’s current policy trajectory would likely lead to stagflation and ultimately a major recession.

He’s not alone. In addition to the World Bank, other major institutions—like Goldman Sachs and BlackRock—have also warned about stagflation risks. And former Fed Chair Ben Bernanke said in May 2022 that the U.S. could be in for a period of stagflation.

While Haworth and Bond agree that concerns about stagflation risks are warranted, current dynamics don’t yet constitute such a phenomenon.

“We don’t have all the features of what one might label as stagflation,” Haworth says, pointing to a still-strong labor market and rising consumer incomes. “We’re not quite in that zone at the moment, but we certainly have to pay attention.”

Meanwhile, McMillan argues that based on the 1970s definition, the U.S. should already be experiencing stagflation—there’s been a supply shock caused by pandemic-related supply chain issues and a significant increase in the money supply due to the Fed’s policies.

But we’re not already in a period of stagflation now, and McMillan isn’t worried about another one happening—because the economy is fundamentally different today than it was back then. It’s showing more signs of momentum than stagnation, he says.

“Right now, inflation is very bad, but the perception is even worse than reality because of gas prices,” says McMillan. “On the one hand, I think it’s absolutely right to be worried about those things, but on the other hand, you need to be as worried about them as the data indicates—and I think people are too worried right now.”

Meanwhile, some economists believe the U.S. has already reached peak inflation.

How to Navigate Stagflation

Whether or not the U.S. is headed for another bout of stagflation remains to be seen. Even in the absence of that label, 2022 has been a difficult year for investors.

Haworth says that investors are battling two headwinds—high inflation and rising interest rates—that don’t necessarily create a clearcut path for investing. “This is the challenge for investors: A lot of things that might normally do well in a slower economic environment aren’t working,” he says. “It’s leaving you with challenging options and challenging choices.”

As a result, it’s important to carefully consider the changes you may make to your portfolio, such as adding more exposure to assets (like commodities) that historically rise in value along with inflation or prioritizing shorter-maturity bonds that aren’t as sensitive to rising interest rates, Haworth says. When weighing big purchasing decisions—like a car, for example—consider whether you can defer or delay the purchase of items where prices may be temporarily elevated, he adds.

McMillan says that there could be some relief ahead if we’ve already reached “peak fear” about inflation.

He adds that paying attention to both the underlying data and the headlines is important. “If you’re an investor, you need to play off expectations as much as reality,” he says.

Finally, even if the pace of economic growth slows or even contracts—as many people on Wall Street are forecasting—investors should focus on tweaks to their asset allocations rather than wholesale changes. “Don’t panic and do something foolish, still kind of stay the course,” Bond says.

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