What is stagflation, and should we be worrying about it?

The strongest inflation in decades and severe shortage of products have evoked comparisons with the economic stagnation facing the United States in the 1970s. Echoes are reviving concerns about “stagflation,” a term coined during that earlier period that has become synonymous with double-digit prices, job losses and images of motorists queuing for gas.

“The danger of stagflation is considerable today,” the World Bank warned this week. “Several years of above-average inflation and below-average growth are now likely.” Here’s what you need to know about stagflation and the potential risk it poses to the U.S. economy.

What is stagflation?

In its strictest sense, stagflation refers to a stretch of rising unemployment along with a sharp rise in prices.

Recently, however, economists have used the term more broadly to mean a period in which inflation remains much higher than the Federal Reserve’s 2% target and the economy slows or even shrinks. . Even if unemployment does not rise, experts warn, a prolonged period of rising costs and stagnant employment growth could be devastating.

High prices squeeze household budgets and reduce consumer spending, while weak economic activity causes companies to grow slowly, if they do, and corporate profits to fall. Financial markets are also suffering, with declining stock and bond values, said Andrew Hunter, senior US economist at Capital Economics.

“For the economy, it’s ultimately the worst of all worlds,” Hunter said.

When did the stagflation last occur?

In the 1970s, this toxic stew of high unemployment and high inflation persisted for more than a decade as did the United States, the United Kingdom, and parts of Europe.

OPEC’s oil embargo in 1973 and the fall in oil production after the 1979 Iranian revolution ended the decade. After the oil-exporting Arab nations stopped exporting oil to the US, the price at the pump quadrupled and oil became scarce. High energy prices increased the cost of producing goods and slowed down the economy. Between 1973 and 1975, the country’s unemployment rate doubled to 9%. Annual inflation peaked at 14% and did not decline substantially until the early 1980s after the Federal Reserve raised interest rates under Paul Volcker.

“It was a very turbulent period for the economy: you had several recessions and overall GDP growth was quite weak,” Hunter said.

Are the 70s about to repeat itself?

As in the 1970s, supply shocks have significantly worsened inflation over the past 18 months. COVID-19 played an important role, as exporting nations shut down or halted production of cars, electronics and other goods, and shipping companies took more months to deliver.

Meanwhile, the Russian invasion of Ukraine in February, after a year of lower world oil production, it has led to a rise in energy prices similar to that of the 1970s, Hunter said.

In contrast, the US economy has also evolved significantly since the 1970s, so it is less certain that we will repeat.

In particular, although energy costs remain significant for industrialized countries, they are less important now than before. Modern economies are more efficient in using oil than in the 1970s, and a much larger share of GDP is made up of services rather than manufacturing. In the U.S., every dollar of economic production needs 70 percent less oil to produce than it did in the 1970s, he said.

Today’s policymakers are also more in tune with inflation than they were four decades ago. Today, most central banks have numerical targets, making it less likely that wild inflation will be lost and allow it to “anchor” itself among consumers. Meanwhile, the economy continues to show resilience, although the axes of growth seem more fragile. Consumers continue to spend at a healthy pace despite higher prices and companies continue to contract.

In short, the economy is not currently facing stagnation, Hunter and other economists told CBS MoneyWatch, although slower growth is a concern for the future.

What is the probability that the stagflation will happen again?

So far, economic data show that inflation may have peaked, while consumer spending remains strong. Online prices fell in May for the second month, Adobe Analytics reported this week. And wage increases, a factor behind rising prices, are also slowing.

But the war in Ukraine and a global food crisis could create conditions that lead to an acceleration in prices.

“Global factors driving prices, especially energy … could keep inflation high or rise even higher, even if the national economy begins to weaken,” Hunter said. .

And if price increases remain high long enough, consumers could begin to expect a steady rise in prices as the new normal and change their behavior accordingly, creating a self-fulfilling cycle of inflation.

Can the US prevent stagnation?

There are two main ways that inflationary pressures can ease, economists say. If supply chain inconveniences were reduced, making cars, electronics, food and fuel more plentiful, prices would fall rapidly, said Chester Spatt, a finance professor at Tepper School of Business in the United States. Carnegie Mellon University.

As for the Federal Reserve, the best way to avoid stagnation is to raise interest rates high enough to curb consumer demand. This is what the Fed did in the 1980s under Volcker, and while it is hailed as a hero among central bankers, a series of recessions occurred when the Fed put the conquest of inflation above the employment growth, made this period a painful one for most Americans.

“They don’t have as many tools to fix supply chain problems. But that means adjusting for demand has to be even harder,” Spatt said. “I think we will see higher interest rates to reduce demand: reduce corporate demand, reduce consumer demand.”

So far this year, the Fed has doubled its target interest rate and looks set to raise it at least three more times by the end of 2022. Rising borrowing costs have already had an effect on the housing market, with rising mortgage rates. from 3% in January to 5% today. The data shows that this drastically reduces mortgage applications while slowing down home purchases.

The risk is that the Fed’s rate hikes will end up stifling growth, rather than just causing it, causing a recession.

“They have to reduce demand. But with 8% inflation, they have to cut demand a lot,” Spatt said. “Can they do it without falling into a recession? That’s a big challenge.”

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• Inflation