Market briefing (no. 40) – 11th October 2021
Stagflation – what is it and why should you be interested?
Generally it is accepted that, in a recession, inflation falls. This is because wages come under pressure resulting in consumers and businesses spending less.
This reduction in spending means that there is less demand for goods and services, which drives down prices for those goods and services leading to a reduction in inflation.
So we are familiar with inflation, but stagflation? What is it and why is being aware of it important?
The term was coined in 1965 by the Conservative MP Iain Macleod. In 1970 Macleod became one of the shortest lived Chancellor’s of the Exchequer (for only one month in 1970), but five years previously on 17th November 1965 – in his capacity as the Conservative spokesperson on economic issues – he said in the House of Commons:
“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.”(1)
So what is stagflation?
Whereas traditional inflation is caused when there is an uncontrolled increase in gross domestic product (GDP)(2) as prices quickly increase to satisfy demand, stagflation is defined (3) as a period of inflation combined with a decline in the GDP(2).
So, stagflation is the combination of stagnant economic activity combined with rising unemployment and higher inflation (3). In turn, higher unemployment causes economic stagnation as people’s capacity to spend is reduced as their earnings have gone down, perhaps even evaporated.
Although Macleod coined the phrase in the mid 1960s, stagflation is forever associated with the next decade, the 1970s. As post second world war growth faded into economic history, stagflation began to take effect on global economies.
From the late 1950s to early 1970s, the US experienced the “Post-War Boom.” Most Western economies saw GDP(2) grow year on year by an average of 5%(4), which caused a slow but steady rise in prices resulting in an increase in inflation.
In the 1960s, the US Federal Reserve (‘the Fed’) believed that the inverse relationship between unemployment and inflation was stable. Thus, when unemployment increased, inflation would fall and vice versa.
This belief resulted in ‘the Fed’ deciding to use its monetary policy to increase overall demand for goods and services which kept unemployment low. They believed the only potential consequence would be a gradual and safe increase in inflation.
However by the early 1970s, ‘the Fed’ began to realise that this relationship between unemployment and inflation was not as stable as they thought and they ended this monetary policy as it was unsustainable.
This withdrawal of US government cash in part led to the oil price increases of the early 1970s. This coincided with the 19 day Yom Kippur war (also known as the Ramadan War or October War) between Israel and a coalition of Arab states which also reduced oil supply significantly; and so began a period of time of what we now know as stagflation (3).
Although the 1970s are traditionally seen as the best example of economies hurt by stagflation, it may be the period after the second world war that provides a better historical example of its potential economic impacts. In the period after 1945, inflation surged in the after effects of post war government spending and the millions of returning soldiers. However, as the 1940s drifted into the early 1950s, the need for these demobbed British servicemen to quickly find new jobs all at the same time led to labour shortages during a period of rising unemployment.
Coming up to date, we are now at the end of the UK furlough scheme as we hopefully approach the tailend of the Covid 19 pandemic. Crucially, unlike previous ‘stagflation’ times, there appear to be many jobs available.
So what about now?
Although inflation is on the rise with specific products being significantly hit – for example, energy and oil prices in the UK – the global economy is not yet experiencing stagflation as GDP is still – albeit fragile – increasing. The more accurate phrase to describe the current economic conditions is perhaps ‘reflation’. As government support and spending stops (such as the UK’s furlough programme) it is expected that the pace of reflation after the pandemic will normalise likely causing temporary economic stresses – such as the energy price spikes we are experiencing now.
That said, policy makers and economists need to be on alert in preventing an inadvertent drift from temporary short-term reflation issues into a more permanent stagflation crisis. As we can see in the news daily, the economic threats caused by a mix of supply chain disruption, high oil prices and labour shortages should be taken seriously, otherwise we will drift into stagflation – which according to Iain Macleod was “the worst of both worlds”.
This means that central banks such as the Bank of England, ‘the Fed’ and others should be very aware to not prematurely tighten their monetary support of their respective ecomomies. As Mark Twain said ‘history never repeats itself, but it does often rhyme” and so although economic history may not repeat exactly, policy makers and central bankers need to remember the events between the early 1950s and 1970s to avoid making similar mistakes and avoid stagflation.
What should this tell you?
Irrespective of historic and current events such as fuel delivery disruption or threats of stagflation, investors should have a balanced, longer term view and should take the appropriate advice in regards to their future financial planning needs.
As we have said many times before, we will continue to monitor the current financial situation and keep you notified of any significant changes that are made. Please contact your Foster Denovo Partner if you wish to discuss your financial situation further.
At times like these, it is even more important that you are taking advice on your finances by a qualified and experienced financial planner. If you think any of your friends, family or colleagues would benefit from speaking to us, especially in the current situation, then please introduce them to your Foster Denovo Partner who would be happy to help.
This week in history …
7th October 2001: U.S. invasion of Afghanistan starts with an air assault and covert operations on the ground (5)
8th October 1945: Microwave oven patented by US inventor Percy Spencer (5)
9th October 1947: First telephone conversation between a moving car & a plane (5)
10th October 1974: Labour Party led by Harold Wilson wins UK general election (5)
11th October 1986: Ronald Reagan and Mikhail Gorbachev open talks at a summit in Reykjavik, Iceland (5)
12th October 1984: IRA bombs the Grand Hotel, Brighton, where PM Margaret Thatcher is staying, 5 die (5)
13th October 1884: Greenwich in London established as the universal time meridian of longitude (5)
14th October 1066: Battle of Hastings: William, Duke of Normandy and his Norman army defeat the English forces of King Harold II who is killed in the battle (5)
Sources & definitions
2) GDP – Gross domestic product (GDP) is the monetary value of all finished goods and services made within a country during a specific period. It provides an economic snapshot of a country, used to estimate the size of an economy and growth rate – https://www.investopedia.com/terms/g/gdp.asp