Ways to deal with Stagflation May 30, 2022

There has been growing concern in recent days over the possibility of stagflation making an reappearance. Stagflation can result from a combination of various factors such as lacklustre or negative economic growth, high unemployment rates and high inflation.

One of these has already made its presence felt – the US inflation rate for February 2022, measured by the Consumer Price Index, increased by a whopping 7.9% on a year on year basis, which is a 40-year record.

There are indications that inflation will continue to remain elevated due to the Russia-Ukraine conflict and President Joe Biden’s ban on energy imports from Russia, which drove prices of fuel up.

Many experts have also predicted that the other two factors will soon come into play. Hence, the US economy could soon see high rates of unemployment and weak economic growth as inflation continues to remain high.

However, there is little consensus over this, as some analysts are confident that the economy is in a strong position and will not enter a period of stagnation.

With this being the case, it would be prudent to analyse some of the potential causes of stagflation and break down the series of events that occurred during previous instances of stagflation.

Reasons for Stagflation

While there is debate among economists over the exact reasons for stagflation, they can be largely explained by either supply shocks or monetary policy, or a combination of both.

Supply shocks are characterised as a sudden and unexpected event that has a serious impact on supply, and consequently, the price of a product or commodity, such as crude oil. Both Brent crude and West Texas Intermediate (WTI) crude futures traded above US$100 per barrel on 24 February 2022, the first day of Russia’s invasion of Ukraine.

It was the first time that crude oil prices surpassed USD100 per barrel since August 2014 for Brent crude and July 2014 for WTI. Prices have stayed elevated above USD100 per barrel since then with some brief respite.

However, it is also crucial to note that Russian oil today makes up approximately 10% of the global oil supply, while OPEC, or the Organisation for Petroleum Exporting Countries, controlled around 60% of global oil supply in the 1970s.

The 1973 Organization of Arab Petroleum Exporting Countries (OAPEC) embargo on the US caused oil prices to rise almost four folds, from USD2.90 per barrel (in 1973) pre-embargo to USD11.65 per barrel (in 1974).

The other often cited cause of stagflation is the introduction of a monetary policy.

During the two previous periods of stagflation in the 1970s and early 1980s, the Federal Reserve had implemented contractionary monetary policies, which can be seen through an increasing Federal Funds Rate.

Contractionary monetary policy is used by the Federal Reserve to bring rising inflation under control. This was the case with the interest rate increase in March. Future interest rate increases are likely to be announced by Federal Reserve chairman Jerome Powell later this year.

However, typically after the Federal Reserve implements a contractionary monetary policy by hiking the Federal Funds Rate, there is time lag before economic indicators such as inflation, unemployment and Gross Domestic Product growth to respond.

During the two previous periods of stagflation, inflation started to decline only around three years after interest rates were increased, on average. However, unemployment and GDP growth reacted more quickly, at around two years on average after the Federal Reserve increased interest rates. When the Federal Reserve changed its course and hiked interest rates in 1973, this resulted in rising unemployment and negative economic growth over 1974-75. However, inflation remained high, at an average of 10.1%.

Hence, the time lag from the interest rate hike in 1973 and the time it took to impact unemployment, economic growth and inflation resulted in stagflation over 1974-75.

Will we see Stagflation?

Some experts have argued that we are not in danger of stagflation due to strong economic growth and a positive employment outlook, with 431,000 jobs added in March 2022 and unemployment rate falling to 3.6%.

US GDP growth for the fourth quarter of 2021 came in at 6.9%, with growth for 2021 coming in at 5.7%, which is the fastest rate of increase since 1984. Hence it seems unlikely that we will see slow or negative growth and high rates of unemployment in the US economy in the near future.

Whether stagflation will occur will depend largely on how quickly inflation goes down in response to the latest round of contractionary monetary policy versus the time it will take for unemployment and economic growth to be affected by the interest rate hikes that have been and will be implemented for the rest of this year.

In the event that stagflation happens, investors should shield their portfolios by moving out of growth stocks, which tend to perform badly in times of high inflation and rising interest rates, and by increasing their exposure to value stocks, that are regarded as trading at a level below what they are really worth, and cyclical stocks, whose value follows economic cycles very closely.

Some examples of cyclical stocks are automobile manufacturers and retailers of luxury goods, while value stocks have a low price to book ratio, low price to earnings ratio and high dividend yield.

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Reference:

• ^[1]https://www.cnbc.com/2022/04/11/oil-drops-brent-crude-falls-below-100-as-china-lockdowns-spark-demand-fears.html
• ^[2]https://www.cnbc.com/2022/02/24/oil-prices-jump-as-russia-launches-attack-on-ukraine.html
• ^[3]https://www.forbes.com/sites/phillipbraun/2022/03/22/why-stagflation-is-not-a-concern-but-there-are-other-things-to-worry-about/?sh=4fd35b3d650b
• ^[4]https://www.investopedia.com/terms/s/supplyshock.asp
• ^[5]https://seekingalpha.com/article/4462851-stagflation
• ^[6]https://time.com/6160043/ukraine-oil-1970s-stagflation/
• ^[7]https://www.federalreservehistory.org/essays/oil-shock-of-1973-74
• ^[8]https://www.nytimes.com/2022/04/05/business/economy/recession-economy.html
• ^[9]https://www.cnbc.com/2022/01/27/gdp-grew-at-a-6point9percent-pace-to-close-out-2021-stronger-than-expected-despite-omicron-spread.html
• ^[10]https://www.nasdaq.com/articles/the-stagflation-threat-and-the-one-strategy-that-will-beat-it
• ^[11]https://www.cnbc.com/2021/11/12/how-to-invest-around-stagflation-inflation-risks-says-analysts.html
• ^[12]https://www.investopedia.com/articles/00/082800.asp#:~:text=Cyclical%20stocks%20represent%20companies%20that,clothing%20retailers%2C%20and%20automobile%20manufacturers
• ^[13]https://www.investopedia.com/terms/v/valuestock.asp
• ^[14]https://www.investopedia.com/articles/economics/08/1970-stagflation.asp

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