Stagflation? Economists say too early to tell

Q1 GDP slumps, inflation spikes, raising concern the world's largest economy is losing steam

May 1, 2022

After the US plunged into its first contraction since the pandemic in the first quarter, is the world's largest economy at risk of falling into a stagflation? Economists said risks are rising, but it is too early to tell.

The dreaded combo of soaring inflation, recession and lower unemployment was fanned anew by a Thursday report that showed that gross domestic product (GDP) slumped 1.4% year-on-year in the first three months.

On its own, the data looked worrisome, especially when you consider that the economy seemed to be losing steam while prices are rising and employment, while still at healthy levels, is showing signs of weakness. But economists warned against reading too much on the data.

"Well, that (report) will get all the stagflation worries out in force! However, we wouldn't get too carried away since the details are not as bad as the headline figure suggests," James Knightley, chief international economist at ING, said in a research note.

IHS Markit, in a separate note, agreed. "The economy was healthier than suggested by the headline number," it said.

The concern though is not unfounded. In 1973, when Saudi Arabia led other oil-producing economies in an oil embargo against the US and Europe, petroleum prices jumped as did costs of other commodities dependent on oil as raw material. That, in turn, hurt businesses which were forced to lay off people, resulting into massive joblessness, and a recession a year after.

Protests spread in the US during the 1970s due to rising prices. — *Protests spread in the US in the 1970s because of rising cost of living and unemployment as a result of stagflation.* Source: ThoughtCo

That has since been known as the era of US stagflation, and it's all because of oil. This time around, petroleum has again become the culprit of America's economic woes. Western sanctions that aimed to cripple the Russian economy have had the collateral impact of pushing global oil prices up. Russia is one of the world's largest oil exporter.

That, coupled with supply shocks from a manufacturing shutdown in China, has put global commodity supplies in a bind just as demand has spiked from consumers coming out of pandemic lockdowns. The knocked-on effect is faster inflation that in turn, tends to cripple growth.

Pandemic: 8.5%

Fed’s target

1.1% in Jun 2002

-2

Global financial crisis: -2.1%

-4

Jan 1983

Mar 2022

Jul 2009

Pandemic: 8.5%

Fed’s

target

1.1%

in Jun 2002

-2

Global financial

crisis: -2.1%

-4

Jan

1983

Jul

2009

Mar

2022

It is normal for inflation to go up or down

But during crises, price swings tend to be larger or smaller than usual.

In June 2002, inflation hit a low of 1.1%, nine months after the 9/11 attacks crippled the economy.

The global financial crisis handed the economy a heavier damage though, resulting in a deflation in 2009 which means prices were instead getting lower.

The pandemic had a slightly similar effect of depressing prices due to economic inactivity.

But when the economy reopened, inflation came back with a vengeance. From about 2% in March 2021...

...it accelerated to 8.5% in March 2022.

And the climb just started last year. Here's how price changes look like across America.

Inflation surge engulfs the US

Year-over-year change (seasonally-adjusted)

2.4%

>7%

March 2019

March 2020

Pandemic

shutdowns

begin

March 2021

Lockdowns begin

to get lifted

March 2022

States have

fully reopened

2.4%

>7%

March 2020

March 2019

Pandemic shutdowns begin

March 2021

March 2022

Lockdowns begin to get lifted

States have fully reopened

Source: Bureau of Labor Statistics

Jeffrey Sachs, economics professor at Columbia University School of International and Public Affairs, said stagflation is not farfetched, but added "it is too early to say" at this point. For him, stagflation occurs only when situations associated with it— recession, high inflation and unemployment— last for "generally two quarters or six months."

That is something Jeffrey Frankel, economics professor at Harvard Kennedy School, does not see happening. For one, he said the job market has remained healthy, with unemployment drastically falling to 3.6% in March from 14.7% at the height of pandemic two years ago.

Growth, he added, is also bound to return next quarter. "I guess that the probability that the US will enter a recession this year is more than in a typical year, but it's still less than 50%," he said.

30%

annual

change

Q1 2022

Oil crisis

Global

financial

crisis

-10

-20

-30

1960

1970

1980

1990

2000

2010

2020

30%

annual

change

2022

Oil crisis

Global

financial

crisis

-10

-20

-30

1960

1980

2000

2020

Like inflation, US GDP has had its highs and lows.

The oil crisis, for instance, pushed GDP down 8% on an annual basis in the second quarter of 1980.

The financial crisis, meanwhile, prompted a recession, which is defined as two successive quarters of contraction.

At the peak of the pandemic, the economy also shrank by most since 1960.

GDP plummeted by a whopping 31.2% year-on-year at the height of lockdowns in the second quarter of 2020.

But unlike 2009, the economy did not suffer a recession and quickly bounced back.

Fears of a recession however were fanned anew after an unexpected dive in the first quarter.

Apart from the when, the how is also a contention when to declare stagflation is unfolding. Carl Weinberg, chief economist at High Frequency Economics, said last September that while inflation is indeed up, its current driving forces are "temporary" in nature.

That said, stagflation risks are indeed rising, and policymakers led by the Federal Reserve are on their toes to prevent it from happening. One way to do this is by focusing on having inflation under control: Fed Chair Jerome Powell and his peers signaled in March that they are set to reduce their purchases of government bonds, which would have the effect of reducing money supply in the financial system.

Theoretically, lower money supply would soften demand, which in turn, could push down prices.

RELATED: Wanna have an idea of the dilemma faced by the Fed and other central banks in fighting stagflation? Play our little game here.

But tackling stagflation could be tricky, and one of the reasons it should be addressed before it even unfolds. Consider what economists are saying the unlikely scenario where GDP continues to shrink. The Fed, back in the 2009 financial crisis, responded to that by lowering interest rates to encourage bank lending, and purchasing bonds to flood the economy with money.

That way, it allows more economic resources to flow so that activity is not restrained. Doing that however, would feed into inflation, a dangerous prescription at this time of already spiking prices.

"Anytime the Fed is obliged to fight inflation by raising interest rates, it could lead to recession," Frankel said. Prinz Magtulis