Why Stagflation Is Back on Some Traders’ Radars

(Bloomberg) -- If 2020 was a year for worrying about pandemic-induced economic collapse and 2021 was when inflation became a focus of anxiety, Russia’s invasion of Ukraine has added to fears that the world may be revisited in 2022 by something not seen much since the 1970s: stagflation. At the very least, the war and the jump in energy prices its onset compounded are likely to complicate the job of central banks aiming for a “soft landing” -- damping down inflation without tipping an economy into recession.

1. What is stagflation?

Stagflation is a portmanteau combining the words stagnation and inflation. It describes an economy with little to no growth and higher-than-normal inflation rates. Iain Macleod, a British politician, coined the term in 1965. Plenty of economists once doubted stagflation was possible. Unemployment and inflation typically move in opposite directions, since price levels are usually driven by an economy’s level of demand.

2. When has it happened?

The most famous episode came in the U.S. during the 1970s. In 1971, President Richard Nixon reacted to balance-of-payments pressures by taking the U.S. off the gold standard. The decision set the stage for a decline in the value of the dollar against other currencies throughout the decade, which added to inflationary pressures at home. Nixon tried imposing wage and price controls to combat inflation without much success. Then in 1973, Arab members of OPEC placed an oil embargo on nations they blamed for supporting Israel in the Yom Kippur War, leading to skyrocketing oil prices. As a result of what economists call a supply shock, U.S. businesses not only passed along those costs but also cut back on production. That made made goods more scarce, adding to a rise in inflation. At the same time, cutbacks in production led to increased unemployment. By 1975, the so-called Misery Index -- the sum of inflation and the unemployment rate -- reached 19.9%. It peaked in 1980 at 22%.

3. Why has the term been revived?

It started with worries about inflation. In the early months of 2021, the rollout of vaccines made coronavirus restrictions seem like a thing of the past. This created a strong rebound in consumer demand that was quickly met with shortages, given that supply chains were still reeling from the pandemic. Prices started to rise. Continued supply bottlenecks began to hold back production, undermining growth, as price increases gathered momentum. Then the appearance of new coronavirus variants like Delta and Omicron raised the prospect of a weaker recovery, while disruptions in the supply of oil and gas combined with surging demand to drive up energy prices worldwide.

4. What happened?

In response to the highest inflation numbers seen in decades in some places, central banks around the world either pivoted or prepared to pivot away from the massive stimulus they’d provided since Covid-19 first hit. In Latin America, many banks raised interest rates sharply, while the U.S. Federal Reserve laid out plans to begin raising rates in 2022, perhaps as early as March. Meanwhile, fears of stagnation eased as economic growth was not slowed as much at the start of the year by the global Omicron outbreak as had first been feared. 

5. How does the Russian invasion of Ukraine change the outlook? 

By driving up prices by threatening supply disruptions, while increasing uncertainty. Oil prices jumped to over $100 a barrel after Vladimir Putin ordered military action, as traders weighed the prospect of disruptions to the flow of Russian oil and gas. The possible loss of other Russian commodities also led to price surges in food, natural gas and aluminum -- spikes that could choke economic activity.

6. How does uncertainty hurt? 

For one thing, it makes it harder for central banks to do their job. With interest rates at rock bottom, and asset purchases maxed out, central banks have little room for maneuver right now. Extending or strengthening stimulus measures may exacerbate price pressures, while stepping on the brakes may sharpen any slowdown the war creates while doing little to address the roots of the inflationary spike. 

7. What does that mean for markets?

Bouts of stagflation have historically been associated with declining profit margins, as companies face higher prices and dwindling sales. During the past 60 years, the benchmark S&P 500 index has returned 2.5% per quarter, but that quarterly return fell to -2.1% during stagflationary environments, worse than returns in environments characterized solely by weak growth or high inflation, according to Goldman Sachs. The setup has historically hit technology stocks hard, while stocks in the health care and energy sectors have generally outperformed.

The Reference Shelf

• The Federal Reserve’s history of “The Great Inflation,” including stagflation.
• A tracker from the Brookings Institution of the Fed’s response to the pandemic.
• Bloomberg Opinion columnist John Authers on why stagflation worries are greater in the U.K.
• A Bloomberg News article on the terms of the stagflation debate.

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