A Stagflationary Shock

If you haven’t already been encountering the word “stagflation”, then you should anticipate hearing it more frequently over the coming weeks.  There are two things that investors dread – low growth and higher prices.  Stagflation implies both simultaneously.

The word stagflation came into vogue in the U.S. in the 1970’s, when sharply higher oil prices combined with (or resulted in) a lackluster economy for much of the decade, but is widely believed to have been coined in the U.K. a few years earlier.  In a speech before Parliament on November 11, 1965, M.P. Ian MacLeod said the following:

“We now have the worst of both worlds —not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of “stagflation” situation and history in modern terms is indeed being made.”

Unfortunately, Britain had a head start on the U.S. in that era’s economic malaise, and Mr. MacLeod died in 1970 only a month into his term as Chancellor of the Exchequer so we will never know how he would have handled the challenges that would have arisen during his term.  Yet his famous phraseology and its explanation survive him decades later. 

Stagflation creates a significant challenge for central bankers.  Remember that their toolkit is rather limited and often inadequate for non-monetary challenges.  Yes, inflation is by definition too much money chasing too few goods, but a central bank can only directly affect the former.  Central bankers have no ability to drill for oil, fix supply chains, or plant crops.  They can indeed affect the amount of money in circulation and the price of that money via changes in interest rates, but their actions simply can’t be targeted enough to avoid side-effects throughout the economy. 

Interest rate hikes and quantitative tightening can dampen inflation, but they also tend to dampen growth.  The problem is that a series of inflation-fighting rate hikes risks dumping an already constrained or fragile economy into recession.   Federal Reserve Chair Paul Volcker is widely credited with breaking the late-1970’s inflationary cycle, but it was a form of economic shock therapy.  He utilized double-digit short-term rates that suppressed an already weakened economy.  The cure worked, but only after a painful few years.

If the stagflationary narrative indeed takes hold, we will need to explore potential winners and losers in greater depth.  Gold, real estate and energy stocks tend to benefit when inflation rears its head, but the latter two have already rallied significantly, and higher rates can dampen the affordability of real estate as well.  High growth tech stocks could skirt the worst of a growth slowdown, but those too are already valued at a premium.  The outlook defies easy answers, except to note that uncertainty breeds volatililty. It is hard to appreciate the degree to which the past few years have been for investors.  We have enjoyed unprecedented fiscal and monetary stimuli and remarkably low interest rates.  All that is likely to change over the coming months, and investors need to hope that central bankers can navigate through a murky environment as well as they accelerated through the prior one