Economic growth is cyclical. It accelerates for a time, and then it cools off. It can’t keep up the same momentum forever.
When markets finally get exhausted, unemployment rises, and economic activity in general slows. Interest rates can rise as a result, leading to slower currency circulation and a stagnant environment in the economy.
But what happens if this cyclical slowdown is exacerbated by unforeseen economic circumstances and large amounts of inflation? The answer is a something that still strikes fear into the hearts of economists, businesspeople, and policy-makers alike: stagflation.
The Specter of Stagflation
In the 1960s and 1970s, the prevailing philosophy was easy money. These policies were designed to facilitate full employment – and they worked, for a while.
However, they led to the unthinkable just a few short years later.
What occurred in the United States in the 1970s is the very definition of stagflation. The country experienced five consecutive quarters of negative GDP growth, and the average price of consumer goods rose almost 7% annually.
Protests in the ’70s, when working people were hit hard by price spikes.
Average citizens were left reeling from soaring prices and interest rates with no sign of economic recovery in sight. Consumers couldn’t even borrow money to relieve the pain of this economic fallout.
Interest rates rose as high as 18.5%, making borrowing money next to impossible for most people.
A situation like that should have been impossible. Prevailing economic theories at the time, such as The Phillip’s Curve, suggested that stagflation could never occur.
Economist A.W. Phillips postulated that inflation was inversely related to unemployment.
Theoretically, high levels of inflation should weaken a currency and make the underlying economy more competitive.
This competitiveness, in turn, leads to job creation and the stimulation of the overall economy.
Unfortunately, the Phillip’s Curve quickly crumbled in the face of the economic reality of stagflation. The economy took almost a decade to recover.
To this day, there’s no consensus regarding the root cause of the 1970s stagflation.
Explanations include the 1973 OPEC oil embargo of the United States, the removal of the gold standard from the US dollar, or then-President Richard Nixon’s kneejerk policy response known as the Nixon Shock.
Stagflation has many causes – but a shock to oil prices doesn’t help.
A common thread runs through all of these explanations – commodities.
Commodity prices erupted by 400% throughout the 1970s.
The natural correlation between inflation and commodity prices meant this wasn’t entirely unexpected. Nevertheless, the sharp rise in prices further intensified a difficult economic situation.
Commodities prices spiked in the 1970’s, hurting consumers.
While authorities can mismanage currencies and attempt to print themselves out of difficult financial situations, they’re unable to conjure physical resources out of thin air.
The combination of thoughtful fiscal policy and time ultimately walked the United States back from the edge of stagflation – and not a moment too soon.
Fiscal policy mismanagement has the potential to throw a massive wrench into natural economic cycles.
Authorities generally create large amounts of credit and cash in an environment of low economic productivity to stimulate the economy.
Under the right conditions, this can result in high inflation levels with little to no impact on the actual economy.
The M1 Money Stock. Look at the right side.
In the wake of the 2008 financial crisis, many observers were concerned over the Federal Reserve’s massive monetary intervention.
Ghosts of stagflation still haunted the minds of many, and rightfully so – the level of fiscal stimulus after the crisis was unprecedented.
Proponents of the intervention cited the swift recovery of the overall economy and the plateauing Fed balance sheet as a stunning success. Stagflation was a thing of the past!
If only economics were so simple.
The Covid-19 pandemic has delivered the two horsemen of stagflation. The economy has all but ground to a halt and is tepidly reopening.
Additionally, the Fed balance sheet has almost doubled and now stands at a whopping more than $7 trillion. Unprecedented fiscal stimulus has to have some impact on inflation.
The Fed’s balance sheet has exploded in the wake of the Covid-19 pandemic
But old habits die hard. Federal Reserve Chair Jerome Powell recently stated that the Fed would welcome higher inflation with open arms.
Careful what you wish for – the US unemployment rate is stuck at a consistent 7%, far higher than the running average, and signals that the economic situation on the ground is far from tenable.
Economists caution that past performance is not an indicator of future success. Central banks must proceed with caution to avoid the malaise of stagflation.
Protecting your portfolio from the economic fallout of stagflation can come in many forms. However, the most straightforward approach is to maintain exposure to assets whose price correlates with inflation.
Could it Happen Again?
Stagflation effects just about every economic metric imaginable: GDP growth, wages, employment, interest rates – you name it.
And in the financial world, there seems to be a sentiment that stagflation can never happen again.
But we can’t take it on faith that stagflation is a thing of the past. In fact, we’re staring down the barrel of economic circumstances that could make stagflation very real.
We entered 2020 riding record stock market highs. It seemed like every other day the Dow broke through to new heights.
Markets were due for some natural correction to begin with. Then COVID hit. And while markets gradually recovered, much of their gains don’t represent real value. Largely, the recovery has been a result of intervention by the Federal Reserve.
Many of the signs seem to be there: huge monetary intervention by central banks, rising commodity prices, an overvalued stock market, high unemployment. Of course, that isn’t to say that stagflation is a certainty. But, at the very least, we can’t rule it out as a possibility.
In order to be prepared for the worst, you’ll need a highly diversified portfolio that features income-generating assets. Learn how Farmfolio’s opportunities in agriculture can provide you with the type of diversification your portfolio will need to withstand stagflation, a downturn, or any other adverse circumstance we may encounter.