What is stagflation and what happens if it comes back?
Australia has enjoyed several decades of low inflation, but this has not always been the norm. The resurgence of inflation over the past few months has raised the possibility of wider economic problems if it is not brought under control.
While higher inflation is usually linked with a booming economy, there are instances where we see the worst of both possible worlds: high inflation and slow or falling economic growth.
This is stagflation, and unfortunately it tends to come hand in hand with high unemployment. Businesses shed jobs because growth is slow, but consumers are faced with job losses and soaring prices at the same time.
Inflation vs stagflation
Inflation normally goes up when the economy is growing, businesses are enjoying good profits and consumers are spending. So long as it doesn't rise so fast that it erodes the value of money, that's generally regarded as okay.
But with stagflation, inflation runs so hot that wages, business profits and the economy don't keep up, leading to bad economic outcomes.
Because it's not part of the normal cycle, stagflation is more commonly associated with events outside the norm. The last time Western economies saw problems with stagflation was in the 1970s when the global oil shock sent prices spiralling and exacerbated the downturn in an already slowing US economy.
Many economists and commentators are concerned we're heading down the same path again with inflation rising due to Covid-related supply problems and the economic fallout from the conflict between Russia and Ukraine and the economic sanctions imposed on Russia.
Australia's March quarter inflation rate came in at 5.1%, driven by the higher cost of fuel (up 11%) and new homes that were impacted by supply constraints.
While this is a huge increase on the 2.1% rate a year ago, Australia is still faring better than most other Western economies. In the US, March quarter inflation was 8.5%, with Europe recording a rate of 7.8% and the UK and New Zealand around 7%.
But the problem with high fuel prices is that they impact on the cost of many other products, triggering the conditions for further price hikes ahead.
It was probably more disturbing that the underlying inflation rate (which strips out large price rises and falls) is now at 3.7% - its highest level since March 2009. So, price rises were happening across a broad range of products and services.
A survey of global fund managers by Bank of America in March found more than 60% of investors predicted the US economy will take a hit from stagflation and more than half expected higher inflation to be permanent.
Is stagflation back?
Neither the US nor Australia is in stagflation territory yet, and with our economy recovering well from COVID and unemployment at just 4%, we are well placed to cope with short-term inflationary pressures.
As Morningstar pointed out in its second quarter review, our supply chain issues that are contributing to inflation are likely to ease as Covid-related restrictions subside. It says interest rate rises should cool the economy and reduce inflationary pressures, and the normalisation of Australian immigration should alleviate pressure in the employment market.
Globally, higher inflation is more of a concern, but at Money press time, most analysts were still predicting the world's economy to grow in 2022, albeit at a slower rate than before the Russia-Ukraine conflict.
Central banks are also more focused now on inflation threats and have already started to try to rein it in through interest rate rises. And while oil prices have risen, they have not skyrocketed to the extent that they did in the 1970s.
What would it mean?
John Rekenthaler, Morningstar's vice-president of research, recently looked at the US in the 1970s and early 1980s when it was hit by three rounds of stagflation.
During the worst, in the mid -1970s, both shares and bonds suffered big losses. But each period was different, depending on expectations of how long the economic slump and high inflation would last.
Rekenthaler found that commodities, including gold, offered some level of protection in investment portfolios, though this varied depending on market expectations of how long stagflation would last.
According to UK data from Schroders, the top performers during periods of stagflation have been gold (22.1%), commodities (15%) and real estate investment trusts (6.5%).
Higher interest rates are also likely to at least take the heat out of residential property.
Did you know?
Australia's highest ever inflation rate was reported at 23.9% in the fourth quarter of 1951 during the Korean war boom. However, we didn't experience stagflation at that time. During the 1970s, inflation topped 17% and unemployment hit levels above 10%.
Given that our economy was recovering well before inflation started to spike, and unemployment was at a record low, we are well placed to get back on track as external influences ease.
A prolonged period of economic sanctions and uncertainty would increase the chances of high inflation and slow economic growth.
The wild card
Global political tensions have been rising over recent years with powers such as Russia and China challenging US dominance. This creates a more uncertain economic environment.
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