What is stagflation and should you be worried about it?

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Highest inflation in decades and severe product shortages have drawn comparisons to the economic slump that the United States faced in the 1970s. double digits, job losses and images of motorists queuing for gas.

“The danger of stagflation today is considerable,” the World Bank warned this week. “Several years of above-average inflation and below-average growth are now likely.” Here’s what to know about stagflation and the potential risk it poses to the US economy.

What is stagflation?

In its strictest sense, stagflation refers to a period of rising unemployment associated with a sharp rise in prices.

Recently, however, economists have used the term more broadly to refer to a period when inflation remains well above the Federal Reserve’s 2% target and the economy is slowing or even contracting. Even if unemployment does not rise, experts warn, a prolonged period of rising costs and stagnant job growth could be devastating.

High prices squeeze household budgets and reduce consumer spending, while weak economic activity means businesses grow slowly, if at all, and corporate profits plummet. Financial markets are also hurting, with stocks and bonds losing value, said Andrew Hunter, senior US economist at Capital Economics.

“For the economy, it’s ultimately the worst of all worlds,” Hunter said.


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When did stagflation last occur?

In the 1970s, this toxic stew of high unemployment and high inflation persisted for over a decade in the US, UK and parts of Europe.

The OPEC oil embargo in 1973 and a drop in oil production after the Iranian Revolution of 1979 ended the decade. After Arab oil-exporting countries stopped exporting oil to the United States, the price at the pump quadrupled and oil became scarce. High energy prices have raised the cost of producing goods and slowed the economy. Between 1973 and 1975, the country’s unemployment rate doubled to 9%. Annual inflation peaked at 14% and did not decline substantially until the early 1980s after the Federal Reserve raised interest rates under the leadership of Paul Volcker.

“It was a very turbulent time for the economy – you had a number of recessions and overall GDP growth was quite weak,” Hunter said.

Are the 1970s about to repeat itself?

As in the 1970s, supply shocks have significantly worsened inflation over the past 18 months. COVID-19 has played a major role, with exporting countries closing or limiting production of cars, electronics and other goods and shipping companies taking months longer to deliver them.

Meanwhile, the Russian invasion of Ukraine in February, after a year of falling global oil production, caused a spike in energy prices similar to that of the 1970s, Hunter said.

By contrast, the US economy has also evolved significantly since the 1970s, making it less certain that we will see a repeat.

In particular, although energy costs remain important for industrialized countries, they matter less today than before. Modern economies are more efficient in their use of oil than they were in the 1970s, and a much larger share of GDP is made up of services rather than manufacturing. In the United States, every dollar of economic output requires 70% less oil to produce than it did in the 1970s, he said.

Policymakers today are also more attentive to inflation than they were four decades ago. Most central banks now have numerical targets, making them less likely to miss runaway inflation and allowing it to take hold among consumers. At the same time, the economy continues to show resilience, even if the foundations of growth appear more fragile. Consumers continue to spend at a healthy pace despite rising prices and businesses continue to hire.

In short, the economy is not currently facing stagflation, Hunter and other economists told CBS MoneyWatch, although slowing growth is a concern going forward.


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How likely is stagflation to happen again?

So far, economic data shows that inflation may have peaked, while consumer spending remains strong. Online prices fell in May for the second month, Adobe Analytics reported this week. And wage increases, one of the factors driving up prices, are also slowing.

But the war in Ukraine and a global food crisis could create conditions conducive to an acceleration in prices.

“Global factors driving up prices, particularly energy prices … could potentially cause inflation to remain high or rise further, even if the domestic economy begins to weaken,” Hunter said. .

And if price increases stay high long enough, consumers might start to expect prices to rise steadily as the new norm and change their behavior accordingly, creating a self-fulfilling inflation cycle.

Can the United States avoid stagflation?

According to economists, inflationary pressures can ease in two main ways. If supply chain problems were to ease, making cars, electronics, food and fuel more plentiful, prices would fall rapidly, said Chester Spatt, professor of finance at the Tepper School of Business in Carnegie Mellon University.

As far as the Federal Reserve is concerned, the best way to avoid stagflation is to raise interest rates high enough to dampen consumer demand. That’s what the Fed did in the 1980s under Volcker, and although he was hailed as a hero among central bankers, a series of recessions that followed as the Fed passed control of the inflation on job growth, made this period a painful one for most Americans.

“They don’t have a lot of tools to fix supply chain issues. But that means demand adjustments have to be even more difficult,” Spatt said. “I think we’re going to see higher interest rates to reduce demand – reduce business demand, reduce consumer demand.”

So far this year, the Fed has raised its target interest rate twice, and it looks set to raise it at least three more times before the end of 2022. Rising borrowing costs have already had an effect on the housing market, with mortgage rates rising from about 3% in January to 5% today. This has significantly reduced mortgage applications while slowing home purchases, the data shows.

The risk is that the Fed’s rate hikes will end up wiping out growth, rather than just slowing it down, triggering a recession.

“They need to reduce demand. But with inflation at 8%, they need to reduce demand significantly,” Spatt said. “Can they do it without tipping into recession? It’s a huge challenge.

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