BY: Jim McElroy
“Stagflation”
Those of us of a certain age remember when we first encountered this portmanteau term for stagnant economic growth accompanied by high inflation. Although the term was originally coined in the UK in the 1960s, during one of Britain’s periods of economic misery, it found its way across the Atlantic in the 1970s and quickly became a favorite term for the economic malaise of that decade (1973 to 1982). On first glance, stagflation appears to be an oxymoron: a stagnant economy should not place upward pressure on prices. But in the 1970s, external events forced an artificial and rapid increase in the price of oil, a raw material effectively essential to every product and service generated by the U.S. economy. At that time, the U.S. was a net importer of oil, and the result was that prices increased and profits went overseas. It’s not surprising that current events, politically and economically, have brought this term back from the distant past: the conditions and causes of the stagflation of fifty years ago are eerily present in the news of the day. Sometimes history both repeats itself and rhymes.
Fifty years ago, there was great turmoil in the Middle East. Israel in 1967 had fought and won the Six-Day War and, in the process, had taken the Sinai Peninsula from Egypt. Egypt closed the Suez Canal to all traffic for eight years, thereby raising the shipping costs for Middle Eastern oil. In 1973, Egypt tried to retake the Sinai Peninsula during the Yom Kippur War and failed. The U.S. monetarily supported Israel in both of these conflicts. In retaliation, the Arab countries, through OPEC, placed an oil embargo on the U.S. and all other supporters of Israel. This embargo only lasted a year, but it signaled that the days of cheap oil were done. Six years later, the Iranian Revolution ushered in a new era of hostility to the West and to Arab countries deemed friendly to the West and/or unfriendly to the Iranian Republic (in 1980, an eight-year war of attrition broke out between Iran and Iraq). As a result of Middle East turmoil and mayhem, the premium associated with access to Middle Eastern oil increased and the prices for goods and services dependent on petroleum-based energy skyrocketed. From September 30, 1973, to October 31, 1982, CPI inflation averaged about 9% per year; this was the “flation” half of stagflation.
The “stag” half of stagflation came about when the Federal Reserve, in its role as an inflation hawk, aggressively pushed overnight rates well into double digits: before finishing in December of 1980, it had driven the overnight rate to a record 22%. Over the entire nine-year period of accelerating inflation and tightening credit, the economy experienced three recessions, nine quarters of negative real GDP, and an average annual return of 2.04% after inflation. This compares unfavorably with the seventy-five-year annual average GDP of 3.21%. Of course, the employment picture during this period was also grim: unemployment climbed from 4.8% in November of 1973 to 10.8% in November of 1982 (there was a four-year period between recessions —from May of 1975 to May of 1979 — when unemployment declined from 9% to 5.6% before resuming its climb to a staggering 10.8% level).
Economies and markets are driven by optimists and risk takers. This was not a good period for optimists. New home buyers (post-war baby boomers) were cowed by double-digit mortgage rates, some as high as 18.8%. Bond investors, attracted by ludicrously high rates – at one point as high as 15.3% for ten-year U.S. Treasuries —invested in long-term bonds only to see their market values drop as interest rates climbed higher. And with T-Bills at one point yielding over 15%, risk takers were in short supply. Of course, the stock market (S&P 500) also had its swoons during this period: two bear markets with declines of 48% and 27%. But, to be fair, it also had its recoveries: two bull markets with gains of 74% and 125%, netting a total gain of about 23% over the full nine years. Positive, yes, but less than a third of the average appreciation of the S&P 500 over historical nine-year periods.
Currently, the Middle East is once again in turmoil: the Iran War and the closure of the Strait of Hormuz, through which some 20% of the world’s oil flows, have driven oil prices sharply higher. The Mullahs of Iran give every indication that they view an apocalypse and the complete destruction of the Middle East and all its oil as a preferable outcome to yielding to the Great Satan (America). We don’t know how long this war will last, but unconditional surrender by Iran does not appear likely anytime soon. And although we have fond memories of the 1970s – polyester leisure suits, platform shoes, discos, shag haircuts, the blinding presence of hot pink as the color du jour – we have no desire to revisit them.
We should point out that there are differences between current conditions and those of the early 1970s: the U.S. is much more energy efficient today than it was in the 1970s and is now a net exporter of oil and natural gas. Increasing oil prices are not likely to provide the shock to the economy that they dealt in the 1970s when America was dependent on oil imports: we do not anticipate seeing long lines of cars at filling stations queuing up for rationed gasoline. And we’re not forecasting a recession or economic stagnation. We do expect continued inflationary pressures on prices as long as the Middle East remains at war. Consequently, it seems unlikely that the Federal Reserve will feel comfortable lowering rates while global oil supplies are shrinking and prices are rising.
It remains to be seen what the outlook for inflation will be once hostilities are finished. Today’s oil prices, unlike those of the 1970s, are the result of much more chaotic and unpredictable forces than the OPEC of the 1970s. In the ‘70s, it was OPEC that set production goals and pricing for oil. Today, production and pricing are being set by a war with an adversary that seems determined to make its oil-producing neighbors pay for its own misfortune of being targeted by the U.S. and Israel. In the earlier period, oil prices could be lowered by turning on spigots. Today, there’s concern that there may not be enough spigots. Eventually, oil supplies will return to what they were before the war. We just don’t know how long that will take.
Summary:
- Stagflation: a portmanteau term for stagnant economic growth accompanied by high inflation.
- Current events suggest that there’s a risk of a return to this malaise of the 1970s.
- Unlike the 1970s, the U.S. is now a net exporter of oil and gas, energy scarcity is unlikely to be an issue.
- Inflationary pressures, however, are likely to increase, the Fed will find it difficult to lower rates as long as the war with Iran continues.
- 1970s-style stagflation does not seem likely.
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