“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’ situation. And history, in modern terms, is indeed being made.”
Iain Macleod, former British Chancellor, November 1965
“From now on, the pound abroad is worth 14% or so less in terms of other currencies. That doesn’t mean, of course, that the pound here in Britain, in your pocket or purse or in your bank, has been devalued.”
UK Prime Minister Harold Wilson, November 1967
“Let me lay to rest the bugaboo of what is called devaluation…Your dollar will be worth just as much tomorrow as it is today. The effect of this action, in other words, will be to stabilize the dollar.”
US President Richard Nixon, August 1971
“America’s humbling defeat in Afghanistan is a big step toward recreating the perfect storm that led to slow growth and very high inflation of the 1970s. A few weeks ago, a little inflation seemed like a manageable problem. Now, the risks and the stakes are higher.”
Kenneth Rogoff, Professor of Economics and Public Policy, Harvard University, August 2021
The term ‘stagflation’ was coined by Iain Mcleod, a British Member of Parliament who later went on to become Chancellor of the Exchequer, in the mid-1960s. He was describing the perilous economic situation facing the UK at the time, with consumer prices pushing higher, despite a stagnating economy. Previously, it was assumed that inflation and recession were mutually exclusive.
President Nixon faced a similar dilemma in the US, in the early 1970s, with unemployment rising above 6%, and inflation pushing over above 5%. Reluctant to raise interest rates with unemployment recalcitrant, Nixon, like UK Prime Minister Wilson before him, decided to tackle these economic problems directly via the currency, in this case removing its convertibility to gold. While this dramatic move played well with the public, at least initially, with the New York Times declaring “We unhesitatingly applaud the boldness with which the President has moved…”, it destroyed the post-war monetary system, ushering in a new era of floating exchange rates and FX volatility. By the end of the decade, the US dollar had weakened by a third.
Today, with inflation showing little sign of being ‘transitory’, and with growing concerns around the robustness of the economic recovery (see last week’s big miss on US nonfarm payrolls as another example of underwhelming economic data), the specter of stagflation looks like it may be about to return. And this is not just a US problem. Last week, Mario Monti, the Italian economist and former Prime Minister (and not one known for hysterical pronouncements), declared that stagflation represents the biggest threat to Europe’s recovery.
The economic factors which plagued developed market economies in the 1970s are all present today. Declining productivity (now exacerbated by COVID), supply shocks (oil crises in the 1970s, and a combination of COVID-related supply chain disruptions and deglobalization today), and huge (unfunded) increases in government spending are all factors which led to stagflation then – so, could it happen again?
It certainly cannot be ruled out. One interesting (and potentially crucial) parallel between today and the 1970’s relates to how central banks view the phenomenon of inflation. In the 1970’s, the Fed concluded that inflation caused by the rising price of oil was beyond its control, but the decline in employment that occurred in response to rising oil prices was something that it needed to respond to. This resulted in the Fed enabling large fiscal imbalances and increasing the money supply, which increased prices without reducing unemployment.
Fast forward 40 years and it could be argued that the Fed (and other central banks) are repeating this error, keeping monetary policy extremely loose to support a fragile economy which has been weakened by factors that will not respond to monetary levers. By attempting to use monetary tools to ‘fix’ problems that are not monetary in nature, the Fed and its cohorts may be setting the seeds for the next stagflation.
This is not a prediction, but rather an attempt to highlight a risk. For if we do see the return of stagflation, the implications for currency markets are profound. Because stagflation arises from serious monetary policy error, it is likely to result in a lack of confidence in the competence of central banks. This typically manifests as a lack of trust in the currency. As mentioned above, the US dollar lost about a third of its value after the ‘Nixon shock’ in the 1970s. Sterling was even more vulnerable, losing more than 30% against the dollar in just over a single year.
As we look out at today’s tranquil FX markets, it is worth remembering the damage that a market storm can wreak, and the return of stagflation would be the equivalent of a precipitous drop in air pressure. As economist Nouriel Roubini recently warned in an article entitled ‘Why stagflation is a growing threat to the global economy’: ‘Make no mistake: inflation’s return would have severe economic and financial consequences. We would have gone from the “Great Moderation” to a new period of macro instability.”