Stagflation In America: Yes, It's As Bad As It Sounds

There’s a spectre haunting America, and it’s called stagflation. This is a portmanteau of two equally fearsome words - ‘stagnation’ and ‘inflation’, and if the Financial Times of London is to be believed, it has arrived in the New World with the merciless force of a Conquistador.

Is this true? Is America, and by extension, some parts of the rest of the world, set to suffer the twin brunt of no growth and high prices for some time to come? It is important that this question be asked, because 2022 was supposed to be a year of recovery, after two torrid years of economic chaos caused by the Wuhan virus epidemic.

According to the latest data, the American economy posted an unexpected contraction in the last quarter, with growth dipping sharply from a robust 6.9 per cent around Christmas, to negative 1.4 per cent by Easter.

As a chart below shows, this abrupt downturn in January to March 2022 (red bar) was accompanied by relentless, record inflation (orange curve), which now hovers at 8.5 per cent.

Allied with these are two more key parameters, which have been demonstrating odd signs of late. First, the 10-year yield on US Bonds has now started soaring, and is at $3 on date (it was $ 2.35 in March 2022, and $2.83 in April 2022).

Readers may note that bond yields are inversely related to their prices, so when yields go up, so do mortgage and borrowing rates. This can cause the American housing market to weaken considerably.

Second, the Federal Funds Rate (FFR) is still well below one per cent. This is the inter-bank lending rate, and is a metric of investment in America. When the FFR goes up, investing in America becomes more attractive.

Ergo, there is currently high inflation, negative growth, declining bond yields, rising costs of home mortgages and loans, and not much incentive to invest in America. All in all, the outlook is bleak.

The Financial Times piece says that forecasts are rapidly deteriorating, even if levels of inflation haven’t reached the double-digit nightmare times of the 1970s, when the Arabs ratcheted up crude oil prices and imposed an oil embargo on Western nations which supported Israel in the 1973 Yom Kippur War.

But there is another war on presently, in Ukraine, and the West has imposed sanctions on Russian crude oil and gas, thereby raising costs to themselves, and dramatically disrupting energy supplies. Consequently, inflation has started soaring in Europe, along with depressed economic activity.

At the same time, demand for hydrocarbons remains low, and the world remains trapped in the midst of an oil glut. Food supply is also an issue, because Ukraine and Russia are major grain exporters. Unemployment has become the West’s bogey, except in Britain; although, there too, experts worry that continued supply disruptions, allied with a tight labour market, could lead to persistent inflation in Britain. On top of that is the epidemic-induced global decline in demand for goods and services.

The problem here is that economists have rarely agreed on solutions to stagflation – not least because they don’t fully understand its causes yet. Worse, the reasons for the current plague of stagflation vary from country to country. As a result, the problem only intensifies month on month even as governments scramble to somehow tackle this truly devastating problem.

Meanwhile, pundits fall over each other to offer trite comments, or to spread a little more alarm. What might happen if the Russians shut off gas to Europe? What if the war escalates? How long will this economic crisis last?

A number of experts also sense that the standard remedy for stagflation – monetary policy – may have numerous limitations, and counterproductive effects, this time. They fear that if central banks increase rates (to attract investments and boost economic activity), that might, in fact, result in hurting “businesses and households at a time when they already see their real income eroded by rising prices”.

Consequently, the solution to this bout of stagflation in America cannot be monetary tools alone, but a simultaneous, rapid boost to manufacturing and consumption on a war-footing as well. The way the country is structured, that can come about only if there is a huge push to increase oil and gas output, along with higher expenditure on defence.

In the ideal world, American pharma would have joined in to complete the unholy trinity of oil, arms and pharma, but unfortunately, an inability to adequately prove the efficacy of American Covid vaccines to the rest of the world, along with the spectacular triumph of British and Indian vaccines, has put paid to such dreams.

Now, Joe Biden has already declared that America seeks to replace Russia as the principal supplier of oil and gas to Europe. At the same time, he has the war he needs to justify higher defence expenditure. But he is not in control of the war or oil prices, and it doesn’t look like he will be able to gain sufficient control of either this year.

Furthermore, his magic wand is limited to America alone – even if he can wave it right. It does little for Europe, since the benefits of heightened activity in the oil patch would principally accrue to the New World; Europe will still continue paying through its nose for the oil it imports, with the difference being merely that the supplier is now America rather than Russia.

It is the same for arms. How much can the Europeans manufacture, or buy from the Americans, without triggering a fresh power imbalance with Russia? More importantly, do they want that, and are they, or their protectors across the Atlantic, in a position to do anything if Russia decides to react?

It is doubtful, because the manner in which the West threw Ukraine under a bus, and stood haplessly by, doesn’t augur too well for Europe’s future security considerations. Besides, history teaches us that arming your way out of an economic crisis can work, but it doesn’t usually have a happy ending.

Therefore, the sad truth is that stagflation in America is now a reality, and will continue to deter recovery, unless and until economic activity is somehow able to outpace these depressing metrics. It is a long shot, with a slim chance of succeeding in a realistic timeframe of six months to a year. If it fails, Biden’s Democratic Party will have to bear the brunt of an incensed electorate, in the American midterm elections of November 2022. God forbid if the American housing market collapses again in the interim.

And the irony is that either way, Europe’s exit strategy from the current mess it is in, will become increasingly contingent upon making peace with Russia – with or without America’s consent.