Stagflation: Morningstar explains

Stagflation was a phenomenon of the 1970s that initially perplexed economists. They assumed there was a positive correlation between economic growth and inflation and that inflation was a sign of a growing economy.

The Phillips curve, a foundational economic concept taught to all economics, finance, and commerce students, specifically states that inflation and unemployment have an inverse relationship. However, the rising inflation and high unemployment levels of the 1970s proved that it was possible for inflation and unemployment to move in the same direction.

In this article we look at the economic concept of stagflation; What is it? How does it happen? And what are the chances Australia experiences it in the near future.

What is stagflation?

Stagflation occurs when inflation and unemployment rises while economic growth falls. This means the economy is experiencing recession like symptoms such as increased unemployment and falling GDP (Gross Domestic Product) while prices continue to rise.

A stagflationary environment differs from that of a regular recession because inflation remains stubbornly entrenched. In a more traditional recession, inflation falls with GDP as consumer demand for goods and service shrinks.

AMP’s senior economist Diana Mousina explains that these economic conditions create a problem for central bankers who use interest rates to simulate or slow the economy.

“If you have a situation where the unemployment rate is high when interest rates are rising, you risk causing a large downturn in the economy and potentially a recession to get inflation down,” she says.

How does stagflation happen?

The best way to understand the origins of stagflation is to look at the 1970s.

During the early 1970s the price of crude oil skyrocketed following the Arab oil embargo. Arab states ceased oil shipments from the Middle East to several countries including the largest consumer of oil, the United States.

The politically motivated embargo resulted in a global energy crisis, and by January 1974 the West Texas Immediate crude oil price had quadruped from US$2.90 a barrel to US$11.65.

The jump in energy prices resulted in rampant inflation with the annual US CPI climbing up to 11% in 1974. At the same time unemployment began to rise and between 1970 and 1974, the average annual unemployment rate was 5.4%.

In essence, the combination of the energy supply constraints with the unwillingness of US policy makers to fully utilise contractionary monetary policy to return inflation to sustainable levels resulted in stagflation.

The longer inflation sticks around the larger the impact on economic activity. Rising inflation creates uncertainty within the economy which impacts consumer behaviour and confidence as well as business investment.

What are the chances of stagflation happening in Australia?

According to Mousina, stagflation may become a reality for Australia. She believes that as the RBA focuses on returning inflation to the target range by use of aggressive rate hikes, unemployment will rise as the economy slows.

“I think we are going to see some sort of stagflationary environment because inflation is likely to be higher than the RBA’s 2% to 3% target band next year and the unemployment rate is also expected to go up from a very low level,” she says.

Despite her belief that stagflation is coming, Mousina is forecasting a subdued version.

“You can see stagflationary periods like this occurring but there are degrees of it,” she says.

“We will experience some level of a stagflationary environment, but the unemployment rate is rising from ultra-low levels. We do expect it to rise back towards 4% but that’s still not high compared to history,” Mousina added.

She forecasts stagflation in Australia to taper off as supply chains begin to normalise. A good deal of the current inflation we are experiencing is driven by supply side issues which remain resilient to changes in the interest rates.

“Some of those supply side issues like supply chain congestion will naturally resolve themselves and that should help that stagflationary environment,” she says.

On the other hand, head of Morningstar equity research Peter Warnes believes Australia is currently on the cusp of more pronounced stagflation.

“You have inflation from the Reserve Bank’s point of view peaking in the fourth quarter [of 2022], close to 8%. So already, you’ve got elevated inflation and you’ve got slowing GDP growth,” he says.

“You’ve got the early stages of stagflation and in my opinion, you will not be able to avoid it,” added Warnes.

He believes boosting economic growth through means other than household consumption will be the key to escaping stagflation.

Economic growth is the aggregate of consumption, investment, government spending and net exports. This means in order to stimulate economic growth at least one of the categories must increase in dollar value.

Warnes sees net exports, government expenditure and private sector investment as stagflation’s version of automatic stabilisers, offsetting the contraction in household consumption.