Why Stagflation Is Back on Some Traders’ Radars

Five months after the Covid-19 crisis knocked the U.S. economy off its axis, inflation seems like the last thing anyone would be worried about. If anything, deflation seems like the more here-and-now risk. But in the gold and U.S. Treasuries markets, there are signs that some investors are worried about inflation down the road. In particular, some traders are signaling concern about stagflation, a rare combination of low growth and high inflation. It’s a minority view, but here’s why it’s in the mix.

1. What is “stagflation”?

Stagflation is a portmanteau combining the words stagnation and inflation. It describes an economy with little to no growth and higher than normal inflation rates. Iain Macleod, a British politician,coined the term in 1965. Initially, many economists doubted stagflation was possible. Normally, unemployment and inflation move in opposite directions, since price levels are usually driven by an economy’s level of demand.

2. When has it happened?

The most famous episode came in the U.S. during the 1970s. In 1971, President Richard Nixon reacted to balance-of-payments pressures by taking the U.S. off the gold standard. The decision set the stage for a decline in the value of the dollar against other currencies throughout the decade, which added to inflationary pressures at home. Nixon tried imposing wage and price controls to combat inflation without much success. Then in 1973, Arab members ofOPEC placed an oil embargo on nations they blamed for supporting Israel in the Yom Kippur War. In the U.S., the embargo led to skyrocketing oil prices. Businesses passed along that cost but also retrenched, as what economists call a supply shock made goods more scarce, adding to a rise in inflation. At the same time, cutbacks in production led to increased unemployment. By 1975, the so-called Misery Index — the sum of inflation and the unemployment rate — reached 19.9% before peaking in 1980 at 22%.

3. What are we seeing now?

The pandemic has replaced a historically strong job market with record levels of unemployment. The unemployment rate in April was 14.7%, four times the rate a year prior. A modest rebound in June and July seemed promising, yet the spread of the novel coronavirus in the country’s South and West over the summer put growth at risk. The surge in stock prices was a powerful sign that many in the market expect a strong, if perhaps delayed, recovery. But the Misery Index for 2020 is on track to be the highest in the U.S. in almost nine years.

4. What about prices?

So far, there’s no sign of inflation. If anything, prices have fallen during the pandemic. But by mid-August, the federal government had passed over $3 trillion in spending meant to keephundreds of thousands of businesses andover 150 million Americans from the brink of economic failure, preventing a recession from turning into a depression. In addition, theFed spent $2 trillion on securities between mid-March and June in an effort to keep the economy afloat. That unprecedented support is part of why equities markets reflect confidence. But to some investors, it seems unlikely that such a vast injection of money into the economy won’t yield higher prices down the road. If that happens while extended damage from the pandemic holds down growth, the elements of stagflation would be in place.

5. What are the markets saying?

Gold prices have been on a rally since March,topping $2,000 for the first time ever in August. The pivot toward gold suggests that some investors are worried about pending inflation, since gold is seen as a secure store of value. In addition to gold, Treasury Inflation-Protected Securities, or TIPS, have become more attractive during the pandemic. The value of TIPS rise with inflation expectations. So-called breakeven rates, the difference between nominal and real interest rates on Treasuries — that is, between the rate without and with an adjustment for expected inflation — have been climbing.

6. What does that mean?

To some investors, that suggests stagflation. To others, however, it suggests that the markets are reacting instead to pledges bythe Fed that it would keep nominal rates near zero even if inflation ticked up a bit. From this perspective, the rallies in gold and TIPS more likely show that investors are reacting to the potential for moderate inflation (and a modest increase in breakeven rates), rather than to the danger of an inflation rate escaping the Fed’s control.

7. So, is stagflation actually coming?

The idea that it will is definitely a minority view. The stagnation half of it seems a real danger if a vaccine is delayed or the damage from the pandemic extends for longer than is hoped. But at this point fears about the inflation side of itseem to be subsiding.

The Reference Shelf:

  • Atracker from theBrookings Institution of the Fed’s response to the pandemic.
  • Bloomberg Opinion columnist John Auther’s predictions for gold.
  • A Bloomberg News article on thegrim outlook for the world economy.
  • A BN article on the reasons to not see stagflation in currentmarket moves.

— With assistance by Matthew Boesler

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