In 1965, the British economy faced a two-pronged assault: weak growth coupled with rapidly rising consumer prices. A British parliamentarian described this paradox by mashing together "stagnant" and "inflation" to come up with "stagflation." The term immediately became a fixture in the financial lexicon and has been striking fear in the hearts of government officials ever since.
Stagflation is the most terrifying of economic circumstances because it is the most difficult condition to combat.
On the one hand you have a slowing economy that calls for an easing of monetary policy to encourage spending. On the other hand, you have inflation spurred on by rapidly rising prices. To deal with inflation, the standard approach is to tighten monetary policy by raising rates to discourage spending. This inherent contradiction makes it difficult to implement an effective policy against stagflation.
How is it possible for an economy to be in such a conflicting state? Certainly this is not a common occurrence, but given the right conditions and an event that causes an extraordinary shock to the economy, both conditions may exist simultaneously.
Some analysts suggest we are close to experiencing those conditions now.
The last case of stagflation in the U.S. happened in the early 1970s. With the economy drifting listlessly, a severe shock was applied in the form of an oil shortage imposed by the Organization of Petroleum Exporting Countries' infamous embargo in 1973 — retaliation against the U.S. for supporting the Israeli military during the Yom Kippur War.
Oil prices jumped by 50% overnight and the disruption in supply caused even more damage. Gasoline service stations throughout Europe and North America were forced to close because of a lack of product.
Once again, unrest in the Middle East is pushing crude prices higher and causing concern over supplies. In the past six months, oil has surged by more than 25% and, at press time, was hovering just above $100 a barrel. This is considerably less than the $145 that crude hit during the summer of 2008. This time, however, few expect the price to retreat and $100 a barrel is now seen by many as the new floor for crude.
The "Out of Gas" signs have not yet been pulled out of the closet, but as violence spreads through the Middle East there is an unmistakable sense of deja vu.
We are also dealing with a "Black Swan" event in the form of the deadly earthquake and subsequent tsunami in Japan. At this point the full extent of the damage is still not clear, but just from a cost perspective it is easily in the hundreds of billions. Global equity markets have been in a straight-line decline since the news broke and no one knows with certainty when the losses will be recovered.
With respect to consumer prices, it appears the other half of the stagflation equation is also forming. According to the U.S. Labor Department's latest producer price index report, food costs jumped 3.9% in February. This is the largest single-month increase since November 1974, when consumer-level food prices rose 4.2%.
The cost of meat and dairy products increased significantly in February, but a full 70% of the PPI rise can be attributed to a massive increase of 48.7% in the cost of fresh and dry vegetables.
The agency places the blame for the jump in food prices squarely on the sharp rise in energy costs and the diesel fuel required to grow, harvest and transport the goods that find their way to the consumer table. Since the beginning of the year, gasoline prices have gained about 40 cents a gallon and diesel has increased even more.
Growing unrest in the Middle East means a likelihood of even sharper increases in the cost of crude and, potentially, supply disruptions. OPEC has said it will attempt to make up any shortfalls, but production capacities are close to maximum already and any significant disruptions could result in a cut in supply.
Time will tell if these conditions mean the U.S. economy will fall into a full-scale case of stagflation. Keep your fingers crossed, because as those of us who survived the last instance of stagflation can tell you, the cure is just as painful as the ailment.
Back then, Federal Reserve Chairman Paul A. Volcker tackled the inflation component by raising the federal funds rate from an average of 11.2% in 1979, to 20% by June 1981. This pushed the prime rate to 21.5%. As prices retreated in the face of the punishing rate increases, the Fed slowly reduced rates to encourage the return of growth. For those with mortgages or a business looking to borrow money to expand their operations, this was a difficult time indeed.
In the end, stagflation was conquered but at a tremendous sacrifice and no one — especially today's policymakers — wishes for a return engagement.
