Revisiting Stagflation: Again

Long before it was a common topic of discussion, I wrote in October about the likelihood of stagflation in 2022 - 2023. Last witnessed in the United States during the 1970s, it was caused by a surge in the price of an essential input that had no good substitutes at that time — crude oil. However, as I discussed then, the surge in the price of oil was itself in response to the sharp increase in US money supply at the beginning of that decade, forcing commodity exporters to react to a loss of purchasing power.

Just as a patient suffering from two maladies is more difficult to treat than someone who has one ailment, stagflation is more painful to end than a mere recession or high inflation. When stagflation combined both recession and high inflation five decades ago, it lasted through the end of the 1970s requiring massive hikes in interest rates and elevated unemployment rates before it could be brought to an end.

Even though oil has substitutes today unlike 50 years ago, covid-induced supply bottlenecks have pushed up prices of a range of items — food and shelter, in particular. Collectively, the sharp increase in price for a basket of commodities have an economic impact comparable to that of crude oil alone in 1973.

Another parallel with the 1970s: Money supply, by its M2 definition, accelerated in growth from 3.7% in 1969 to over 13% in each of 1970 and 1971 as President Richard Nixon sought to find easy money to finance the Viet Nam war. Further debasing the dollar was the decision in August 1971 to end the currency’s convertibility into gold. Not surprising that oil producers tired of being paid in depreciating dollars and tripled the price of a barrel of oil in 1973.

More recently, the Federal Reserve, under the leadership of Jerome Powell, decided in early 2020 to fight recession by buying Treasurys and mortgage-backed securities. As it continued the process long after the economy had started to recover, the Fed’s balance sheet has more than doubled from about $4 trillion to almost $9 trillion in just two years.

Any surprise that inflation was not “transitory” but, instead, has become ingrained in consumer expectations? It is also not shocking that workers with any skill at all are able to demand large pay hikes and get them. The two developments help perpetuate high inflation rates.

What next? Expect the Federal Open Markets Committee to raise interest rates by just 25 basis points on March 16 with the central bank’s balance sheet continuing at its current bloated level. This is in the context of a sharp increase in energy prices — déjà vu en 1973 — especially after the start of the Russian invasion of Ukraine. Brent crude prices have climbed by 59%, natural gas by 66% and coal by 181% over the past year.

In turn, that is likely to keep inflation at levels not seen in four decades. While, this time, Powell is unlikely to suggest that energy-related inflation is “transitory,” he may also not want to take stern measures to control it. The necessary, but unmet, measures would include initiation of a reduction in the balance sheet and confirmation by the Chairman of a calendar for steady increases in the Federal Funds rate by the end of 2022 to, say, 2% from the current 0 - 0.25% range. After all, why would Powell do that to the detriment of equities, much as then-Chairman Ben Bernanke found in 2013 when his announcement resulted in a “taper tantrum”?

Not wanting to cause a steep equity correction in a politically important year would essentially kick the can down the road in terms of adopting anti-inflationary measures — perhaps until after the November mid-term elections. By that time, irrespective of how the Ukraine crisis is resolved and how high energy prices go, it would be obvious that the Federal Reserve’s measures turned out to be too little, too late.

President Joe Biden will have to start thinking about how to bring inflation down to normal levels well before the presidential elections of 2024. The historical precedent is not a positive one. For President Jimmy Carter, it involved persuading Fed Chair G. William Miller in August 1979 to leave the Chairmanship to move to the Treasury after just 17 months on the job. Carter brought in Paul Volcker to the Fed, arresting inflation but only by using measures that resulted in a severe recession and costing Carter the 1980 election.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

February 27, 2022

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