Nick Reece, Merk Investments

June 9, 2022

“Supply shocks are stagflationary,” writes Ben Bernanke in his new book. Supply shocks constrain output and reduce the capacity of a national or global economy to produce real goods and services for consumption. Therefore, they shrink GDP—and the natural policy response to an economic downturn is to provide support through fiscal and monetary stimulus. However, in a capacity-constrained economy, such support mainly works to increase nominal prices rather than increase real output.

In other words, the typical reaction of policymakers is to stimulate a stalled economy by pumping up aggregate demand. But that knee-jerk answer ignores the underlying cause of the problem. When the output potential of an economy is temporarily capped, those stimulus programs are highly inflationary. In a supply shock, the contraction is not due to a lack of aggregate demand in the first place.

To add insult to injury, as inflation worsens, there may be political pressure to provide even more fiscal support so that households can “pay for all of the inflation.” Many politicians do not realize that adding more money into the system does not magically bring about increased real output (i.e. actual goods and services). If overdone, relief payments can disincentivize a return of the supply-side, for example as seen in the labor force participation rate. As a general rule, no amount of artificial stimulus can produce a real economic outcome superior to a naturally fully employed economy. In an inflationary period, you might also hear politicians shifting blame and scapegoating capitalism, monopolies, or “price gouging.”

Stepping back for a brief introduction, stagflation refers to a combination of weak economic growth and high consumer price inflation. Just as it sounds, the term itself is a compound word joining together stagnation and inflation. The stagnation part is typically associated with high unemployment, and therefore stagflation tends to describe a period of both high unemployment and high inflation.

As an economic outcome, stagflation is at odds with the original concept of the Phillips Curve (established in 1958). The Phillips Curve theory suggests that high unemployment leads to low inflation, and low unemployment leads to high inflation. That framework is reasonably accurate when primarily considering changes in aggregate demand, but it leaves out some key considerations of aggregate supply.

The degree of stagflation can be measured by the so-called Misery Index^[i], which adds the unemployment rate and the inflation rate together. For example, if annual inflation is running at a pace of 7% per year and the unemployment rate is 5%, the Misery Index would be 12.

A British politician, Iain Macleod, coined the term stagflation in 1965 when he said, “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.” For its part, the term “Misery Index” was created by economist Arthur Okun in the 1960s and popularized by Jimmy Carter in his successful campaign to defeat Gerald Ford in the 1976 Presidential election. Ironically, the Misery Index would only get worse under Carter—perhaps contributing to his defeat in 1980.

In my assessment, the recipe for stagflation has two main ingredients: 1) exogenous negative supply shock(s), and 2) policy error(s). Potential sources of supply shocks include war, sanctions, natural disasters, and pandemics (clearly), among others. Policy errors can come from a range of sources: fiscal policy, monetary policy, public health policy, trade policy, energy policy, and foreign policy, among others. Multiple supply shocks can be met with multiple policy errors. Some of the errors are made before the exogenous shocks occur, and only become more obvious afterwards. These errors are not necessarily just in the US, but in other parts of the world as well. A recent international example of a pre-emptive policy mistake was Germany’s decision to shut down domestic sources of clean energy (nuclear), causing them to become more reliant on Russian fossil fuels (oil & gas).

For the most part, the policy responses that would offset the inflation of supply shocks are politically unattractive—and tend to involve bringing down aggregate demand. Conversely, policies that would increase supply are sometimes at odds with political constraints (either perceived or real), e.g., increasing immigration, work visas, etc. Nevertheless, policies that focus on incentivizing a recovery on the supply-side are best suited to getting out of stagflation. An increase in aggregate supply is both pro-growth and disinflationary.

Turning to the general macroeconomics of inflation, the consumer price level is a function of nominal aggregate demand relative to real aggregate supply. Consider this simple equation: consumer price level = nominal aggregate demand / real aggregate supply. If real aggregate supply experiences a negative shock, and the productive capacity of the economy is temporarily hindered, adding nominal aggregate demand won’t increase real output, it will just increase the price level. In a negative supply shock, the government can replace lost income, but it can not replace the lost production of real goods and services. As one manufacturing entrepreneur phrased it, “The economy isn’t a magic Horn O’ Plenty.” Companies and their workers need to produce goods and services for there to be goods and services to consume. Simplistically, nominal purchasing power (the numerator) can be maintained, but a decline in real output (the denominator) leads to a higher price level (inflation). If the supply shock is one-off and temporary, such inflation can be said to be transitory–meaning there is a one-time shift higher in the price level. In that situation, the best policy response may be to let the supply-side heal naturally and accept that the policy options are limited. Overzealous and impatient (albeit well-intended) policies can make matters worse.

Fiscal stimulus programs in the form of direct payments to low-income households are particularly inflationary. Low-income households have what economists call a high marginal propensity to consume (MPC). A dollar received by a low-income household is likely to be quickly spent on consumer goods (gas, groceries, appliances, etc.). In other words, low-income households are likely to spend most (if not all) of their next dollar of income on basic living expenses.

Alternatively, direct payments (or tax cuts) to high-income households are not particularly inflationary as high-income households tend to have a low marginal propensity to consume and a high marginal propensity to save (MPS). As such, tax cuts to the wealthy are more likely to lead to asset price inflation than consumer price inflation.

The Federal Reserve, tasked by Congress, is responsible for price stability. But fiscal policy could be used to tame inflation as well. Specifically, tax increases reduce consumer purchasing power. Due to their high marginal propensity to consume, tax increases on (or reduced direct payments to) low-income households would almost certainly reduce inflation but would be politically unpopular.

Turning back to the historical perspective, the most notable example of stagflation happened in the 1970s. Starting in 1967, inflation ran above 2.5% per year for the next 15 years. Economists refer to this general period as The Great Inflation (1965-1981). It was most notably characterized by exogenous supply shocks in the oil markets. Furthermore, ill-advised fiscal policy and timid monetary policy exacerbated the problem. The Fed’s “stop-go” monetary policy under William McChesney Martin, and more notably under Arthur Burns, arguably never went far enough to offset expansionary fiscal policy.

Behind-the-scenes Fed/Whitehouse politics can make it difficult to take the necessary actions. To draw a parallel to the current environment, as Larry Summers pointed out early last year, Biden’s $1.9 trillion American Rescue Plan in March 2021 went way beyond what was needed to support those put out by the pandemic. And yet, fiscal and monetary policy tends to be coordinated in the fervor of “crisis mode.” In other words, fiscal and monetary policy tend to work in the same direction in an economic crisis. It would have been politically difficult for the Fed to act to undo the stimulative effect of fiscal policy, particularly at a time when vaccines were just getting rolled out and new waves of the pandemic were ongoing. Arthur Burns (Fed chair from 1970-1978) described the challenging politics of monetary and fiscal policy in a 1979 speech titled “The Anguish of Central Banking.”

Perhaps the biggest policy mistake during the period of The Great Inflation was wage and price controls. Initiated in 1971, the controls deprived the free market economy of the price signals necessary to effectively allocate scarce resources and had the perverse effect of actually incentivizing supply destruction. For example, farmers slaughtered livestock rather than sell them at a loss. As previously stated, the only disinflationary policy response to a negative supply shock is to reduce aggregate demand or incentivize aggregate supply (e.g., through immigration, deregulation, etc.). Though well-intentioned and initially popular, the wage and price controls of the Nixon administration had the effect of actually reducing supply and further fueling inflation.

To exacerbate matters, when inflation becomes entrenched in consumer psychology, it can become a self-fulfilling prophecy. In the 1970s it was referred to as a “wage-price spiral,” which is just a convoluted way of saying inflation became self-fulling through increased inflation expectations. This is why policymakers at the Fed closely watch both market-based and survey-based measures of inflation expectations and are fearful of expectations becoming “unanchored.”

Having discussed the economics and politics of stagflation, what could a stagflationary environment mean for the financial markets today? Historically, consumer price inflation tends to correspond to asset price deflation. For one thing, inflation tends to lead to higher interest rates. Higher interest rates mean future cash flows are discounted back to present value at a higher discount rate. With higher inflation, savers need to be compensated for the higher opportunity cost of deferring present consumption for future consumption. All else equal, the higher the discount rate the lower the present value. In other words, more emphasis is put on cash flows today compared to cash flows tomorrow. Generally, a rising discount rate has a depressing effect on both stocks and bonds. Treasury bonds are normally an effective diversifier to equities. But in a stagflationary environment, the traditional 60/40 portfolio (60% stocks and 40% bonds) may be vulnerable. Within the equities asset class, stock prices of companies that are free cash flow positive tend to fare better than stock prices of companies that are a free cash flow negative. Additionally, the stagnation part of stagflation suggests that underlying earnings might grow at a slower pace due to slower overall economic growth. So, you potentially get valuation multiple contraction (e.g., a decline in the price-to-earnings ratio) combined with slower earnings growth (the denominator of the price-to-earnings ratio).

Not that it’s directly investable, but the CPI Index^[ii] outperformed the S&P 500 Index during the period of The Great Inflation (1965-1981). Cumulatively over that period, the CPI Index was up 195% whereas the S&P 500 Index (excluding dividends) was up just 33%.

So, is the US economy in stagflation now? The next economic downturn will be telling. The real test as to whether we are in a stagflationary environment is going to be if inflation continues to run above trend (e.g., above 2.0%) through a recession and corresponding increase in the unemployment rate. But the risk is clearly there. As the Fed put it in their May meeting minutes:

“The staff continued to judge that the risks to the baseline projection for real activity were skewed to the downside and that the risks to the inflation projection were skewed to the upside. The war in Ukraine was seen as a possible source of even greater upward pressure on energy and commodity prices, while the war and adverse developments associated with rising COVID infections in China were both perceived as increasing the risk that supply chain disruptions and production constraints would be further exacerbated in the United States and abroad.”

Many economists argue (I think rightly so) that globalization since the fall of the Soviet Union and the liberalization of China created secular disinflationary forces. Indeed, US consumers have seen persistent durable goods deflation over the past three decades (up until the pandemic that is). If the world is now going through a period of deglobalization, that trend may be reversed—at the least for a time. The loosest definition of transitory is merely something that is not permanent. If the deglobalization, onshoring, “just-in-case” inventory trend is genuine, inflation might be transitory—it just might be transitory over a 5-10 year period.

Nick Reece
Nick is co-portfolio manager of the Merk Stagflation ETF (NYSE:STGF).

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[i] Misery Index measures the degree of economic hardship felt by the average household. It is calculated by adding together the unemployment rate and the inflation rate.

[ii] Consumer Price Index (CPI) is a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services.