The economy is slowing. Inflation is climbing. Investors are worried that these trends appear to be a recipe for the “S” word.
The economic concept of stagflation where the witches’ brew of a faltering economy, aided and abetted by skyrocketing inflation, harkens back to the malaise of the late 1970s. At that time, interest rates rose to nearly 20%. Inflation, as measured by the Consumer Price Index (CPI), reached an annual average of 13.5% by 1980. Oil prices (like today) surpassed $100/barrel.
Blame for this period of stagflation fell squarely on OPEC, a newly formed energy cartel of oil producers, who decided to raise oil prices sharply after decades of artificially controlled, suppressed prices by mostly Western nations and their energy producers.
Since energy is used in so many of the industrialized economies to produce just about everything, this oil shock reverberated throughout the economy. As costs rose, prices pushed higher causing more and more inflation (sound familiar?). It didn’t help that for the most part; monetary expansion was the name of the game throughout most of that decade.
Looking back, economic growth and unemployment in the 1970s was uneven at best with two recessions, one at the beginning of the decade, and another from 1973 through 1975.It’s not hard to point to the similarities between then and now.
Today, we are confronting similar supply shocks, which began during the pandemic and have since been amplified by the onset of the Ukrainian War. We have also been functioning under a highly expansionary monetary policy that has been in place since the financial crisis of 2008-2009. Where we differ today is in the areas of economic growth and employment. Neither qualify as coming even close to stagnation.
Proponents of stagflation would say that it is only a question of time before the economy slows and is in fact doing so as I write this. They would be right, at least in the short-term. Most economists expect this present quarter to register anemic growth. Yet, for the year 2022, the expected growth rate is still 3% and 2.3% for 2023.
However, the Russian invasion of Ukraine and the resulting sanctions may trigger recessions in both warring countries. Theses actions will also spill over to the European Community (EU) and directly impact its economies. It will also create even further supply chain obstacles and higher inflation.
One would expect that the U.S. economy will feel these impacts as well. The Conference Board estimates that these headwinds could cut as much as half a point or more from our growth rate. On the unemployment front, we are nowhere near where we were in the 1970s. Right now, unemployment is at a low of 3.8%. And readers must remember that global economies are less energy intensive than they were back then. In a research report, UBS Wealth Management USA argued that “oil intensity of global GDP has dropped by 25% since 1990 (and by more than 50% since the early 1970 when oil price shocks caused recessions).”
However, what we don’t know is what economic impact the Fed’s intention to tighten monetary policy will have on the economy. Investors point to what happened when Federal Reserve Chair Paul Volcker addressed inflation back then. He raised interest rates to double-digit levels, drove inflation down, but also sent the economy into a deep recession. Could the Fed do that again?
I doubt that today’s Fed will ignore the past and simply “do another Volcker.” But make no mistake, the Fed is going to raise interest rates next Wednesday, March 16, by 25 basis points and likely raise rates again at the next two meetings. How will the markets handle that?
We are at the lower end of the box on the S&P 500 Index (the lower end of that box is 4,310, give or take 20 points). I believe markets will continue to move on every headline between now and the FOMC meeting next Wednesday. In the meantime, stocks are managing to hold up and will continue to do so, barring a game changer in the Ukraine conflict.