Stagflation: Back to the 1970's?

“Stagflation” is a phenomenon that has not recurred in the United States for almost a half century. It refers to the developments of 1973 - 1975 when sharply higher global oil prices simultaneously caused economic stagnation and a surge in inflation.

Despite a recovery from that recession, the economy fell into the grip of slow growth and high annual inflation rates for the rest of the 1970’s. A massive tightening of monetary conditions, including hiking the federal funds rate to over 20%, was necessary to bring inflation down to manageable levels. And the rate increases prompted another severe recession in 1981 - 1982.

No wonder stagflation conjures up fears that a mere threat of recession does not. For a number of reasons, the “S” word has been mentioned more times in recent weeks than in past years.

To understand the growing risk of stagflation, it would help to understand what caused the conditions of 50 years ago. Prompted by the growing financial requirements of pursuing the Viet Nam war, and backed by a pliant Federal Reserve, growth in the the M2 definition of US money supply accelerated from 3.7% in 1969 to 13.0% or more in both 1971 and 1972.

While it became commonplace to blame the Arab oil embargo of October 1973 and the subsequent increase in global energy prices for the pickup in inflation, oil producers had been steadily losing purchasing power in selling crude oil for about $3 per barrel during the early years of the decade. Even a cartel could not have successfully tripled oil prices over the decade without the tailwind of a surge in dollars in circulation. With no good substitute for imported oil in the developed world, inelastic demand led to a drop in purchases of other goods and services, leading to the recession.

Fast forward to 2020 - 2021. Oil has a growing number of substitutes today with electric cars and solar energy steadily rising in importance. However, rather than just one item whose price rose and was indispensable in the 1970’s, a whole host of items are affected by supply bottlenecks in the aftermath of covid. As Federal Reserve Chairman Arthur Burns (1970 - 1978) oversaw the surge in money supply, we have Jerome Powell who has more than doubled the Fed’s balance sheet since just before covid began. This is an even larger monetary feast than it was in the 1970’s.

However, US economic growth is slowing in the second half of 2021. While the Fed has attempted to keep the monetary stimulus flowing, the persistence of high inflation rates will limit the central bank’s ability to continue to do so. What is worse, expect the Fed to be forced to raise interest rates next year despite slowing growth. The end result would be — you got it — stagflation.

What of the global economy, you may ask. Unlike in the 1970’s when the US was the sole leading economic power, we now have a very different and a much more developed China, the second largest economy in the world. China joining the World Trade Organization in 2001 gave rise to greater global interdependence and, in particular, a shift in the production chain toward that country. This, in turn, moderated global inflation.

Over at least the next couple of years, China is likely to be a drag on the global economy rather than provide a boost. Hobbled by corporate debt issues, China is likely to slow markedly over the coming years. So expect little help there in limiting US stagflationary pressures.

With a decision expected soon on whether he will renominate Powell for another term as Chairman of the Federal Reserve, President Joe Biden and his team of advisors have a lot of thinking to do. President Jimmy Carter decided not to renominate Burns in 1978 but his choice as successor of G. William Miller — a corporate executive with no financial sector experience — turned out to be a poor one. Inflation surged further, and the subsequent monetary tightening and recession were factors in
Carter becoming a one-term President.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

October 3, 2021

Sri-Kumar Global Strategies, Inc. advises multinational investors and sovereign wealth funds on global risk and opportunities.  Dr. Sri-Kumar is regularly featured on business TV and Radio media, and is a frequent speaker in global financial centers on major topics that affect markets and investments.

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