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Stagflation concerns: are the 1970s coming back?

Inflation is soaring in the world’s largest economies now. In the U.S., consumer prices are racing at their quickest level since the 1990s. In China, factory gate prices rose at the fastest pace in 26 years in October, beating forecasts and further squeezing profit margins for producers already grappling with soaring coal prices. Germany, the fourth-biggest economy, is among other nations seeing the same trend. The climbing inflation worldwide, combined with slowing economic growth, fuels concern over the increasing possibility of stagflation in the following years.

Stagflation concerns: surging inflation and tumbling consumer sentiment

In the U.S., consumer prices rose at an annual pace of 6.2% in October, on track for their highest annual gain since 1990, a surge that analysts have pinned on everything from soaring commodity prices to some $5.3 trillion in U.S. fiscal stimulus passed since the start of the pandemic. Meanwhile, the third-quarter U.S. economic growth is expected to fall to 2.7%, from the prior quarter’s 6.7% rate.

On the other hand, consumers are reaching a breaking point. Friday’s University of Michigan Consumer Sentiment Index release came in below expectations, in large part because of inflation. The consumer sentiment index slipped to 66.8 in November, down from 71.7 in October and well below economists’ forecast for a stronger reading of 72.4.

Along with the disappointing economic data, people start worrying about whether the economy is heading for a stagflation phase: Google searches for “stagflation” this month are on track to hit their highest level since 2008. Goldman Sachs also said that stagflation has become “the most common word in client conversations” recently. Moreover, a survey from BofA Global Research showed that the number of fund managers expecting stagflation rose by 14 percentage points in October to the highest level since 2012, demonstrating increasing concern over stagflation among institutional investors.

While it is no wonder that headlines associate the heated inflation today with the stagflation in the 1970s, it is suggested that we look back to the last stagflation period in history before jumping to conclusions of whether stagflation is coming or not.

 What happened in the 1970s?

The stagflation in the 1970s was associated with high oil prices, double-digit inflation, unprecedented unemployment rate, and negative GDP growth for years.

In 1974-75 at the end of the Nixon government and the beginning of the short-lived Ford administration, the unemployment rate reached 9%, the highest it had been since the Great Depression. Meanwhile, the American cost of living increased 133% between 1972 and 1982. Between 1973 and 1974, and again between 1974 and 1975, as the Gross National Product (GNP) failed to grow enough to counter the inflation rate, the Real Gross National Income (GNI) therefore declined.

Things grew worse as the ’70s advanced. On 17 December 1978, OPEC representatives announced their decision to raise export prices by 14.5% during the coming year. In November 1979, the price per barrel of West Texas Intermediate crude oil surpassed $100 (in 2019 dollars) and peaked at $125 the following April. That price level would not be exceeded for 28 years. The prevailing belief has been that high levels of inflation were the result of the surging oil price and the resulting increase in the price of gasoline, which drove the prices of everything else higher, which is known as cost-push inflation. As a result, the surging oil price pushed the core consumer price index up to a high of 13.5% in 1980, prompting the Fed to raise interest rates to nearly 20% that year.

Bonds also struggled during the last major stagflationary period, which began in the late 1960s. The benchmark 10-year U.S. Treasury fell in nine of the 11 years leading up to 1982, according to data compiled by Aswath Damodaran, a professor at New York University. This is because inflation erodes the purchasing power of bonds’ future cash flows.

How is today different from it?

Despite growing concern over the coming back of the 1970s, it is believed that today’s inflation is mainly driven by the post-pandemic supply-demand mismatch, which is fundamentally different from the 1970s when the supply had almost reached its full capacity.

If we look at the long-run chart of U.S. capacity utilisation, which demonstrates the relationship between the output produced with the given resources and the potential output that can be produced if capacity was fully used, capacity utilisation remains depressed, suggesting that once the pandemic fades, disinflation, or outright deflation, will re-emerge. In other words, there has been a long-term trend toward increasing oversupply.

Graph by Bloomberg.

During the pandemic, supply chains have become stretched as consumers reallocate consumption and manufacturing hubs have faced shutdowns and stoppages due to coronavirus outbreaks. However, arguably, low capacity utilisation can help entrench disinflation in the coming years, as excess capacity should exert downward pressure on price levels.

This situation is not like the 1970s when capacity utilisation hit almost 90%. It makes sense that central banks consistently consider inflation today as transitory and become very cautious when it comes to rate hikes. As raising rates to combat inflation is mostly about curbing demand by reducing money supply growth via making borrowing more expensive, it works with a considerable lag. The supply chain bottlenecks could be over before the policy shift kicks in. It is clear central bankers feel that acting now could backfire once supply constraints are removed, so they have sat on their hands as inflation has spiked.

Wall Street banks don’t seem to worry either

Many investment banks on Wall Street also reject comparisons to the 1970s, arguing that the causes of the current bout of inflation are either overblown or likely to fade.

Jean Boivin, Head of the BlackRock Investment Institute, expects growth will accelerate as supplies become more readily available and is positioned for Treasury yields to move higher. “The inflation pressures we expected are here,” he wrote in a recent report. However, “this is not stagflation, and we remain pro-risk.” This echoes analysts at UBS, who said that in addition to higher oil prices, stagflation in the 1970s was driven by factors that are less meaningful today, including government price controls that constricted supply. Scott Kimball, Co-Head of U.S. Fixed Income at BMO Asset Management, believes that most of the spending in a potential infrastructure bill – a key worry for inflation hawks – is long-term and would not have an immediate economic effect.

References

https://www.theguardian.com/commentisfree/2021/oct/20/ignore-the-fearmongers-the-1970s-are-not-coming-back

https://www.reuters.com/business/1970s-all-over-again-stagflation-debate-splits-wall-st-2021-10-27/

https://www.reuters.com/business/hot-us-inflation-drives-dollar-2021-peaks-2021-11-11/

https://www.cnbc.com/2021/11/10/chinas-producer-prices-rose-at-fastest-pace-in-26-years-in-october.html

https://www.ubs.com/global/en/wealth-management/insights/chief-investment-office/market-insights/paul-donovan/2021/driving-inflation.html?caasID=CAAS-ActivityStream

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