Ray Dalio's Warning of a Prolonged Recession in 2022 (Stagflation Explained)

Over the past few months, many economists and investors like Ray Dalio have come out and predicted an upcoming period of stagflation in the United States. Sounds like a weird and scary term, but as the name suggests, it simply means two things occurring at once: economic stagnation and inflation. It's also called recession inflation. It means that inflation is high in an economy that's weak, and this is unusual because normally inflation comes about as a result of a booming economy. Interest rates are low, unemployment is low, demand is high, and business is booming. Thus, producers have so much demand they can raise their prices. Workers start wanting more money for the same work, and inflation starts to rise. That's normally how it goes.

But stagflation is an unusual economic scenario where inflation is high in an economy that's struggling and unemployment is rising. This is a particularly painful situation for those controlling economic policy, as actions to control inflation, like raising interest rates, will only make a bad economic situation worse, causing even higher unemployment and even tougher financial conditions for businesses and citizens. So why does it happen?

Stagflation seems a little counterintuitive. Usually, when economic conditions worsen, this leads to lower inflation, and conversely, when economic conditions improve, this leads to higher inflation. Well, economists say that stagflation can only really occur in two scenarios: when there's a sudden supply shock or when there's really poor management of a country's monetary policy.

Firstly, supply problems. When an event suddenly chokes the supply of necessary goods, like food crops or oil, this causes prices to rise across the board. Prices of both the commodities as well as all the other products that somehow rely on them at some point along the chain. So prices go up due to scarcity. But on top of that, having a scarcity of such fundamental economic commodities like oil will also reduce production capabilities, and that impacts economic output. Thus, you get stagflation: prices rising and economic conditions worsening.

That was a big contributor to the stagflation of the 1970s. In 1973, the members of the Organization of Arab Petroleum Exporting Countries proclaimed an oil embargo targeted at Canada, Japan, the Netherlands, the UK, Portugal, Rhodesia, South Africa, and, you guessed it, the United States. By the end of the embargo in March 1974, the price of oil had risen nearly 300% from three dollars a barrel to nearly 12 dollars a barrel globally. The average U.S. retail price of a gallon of regular gasoline rose 43% from May 1973 to June 1974.

So there's the inflation, but because oil is such an important industrial resource, it also hit America's economy. State governments asked citizens to not put up Christmas lights. Oregon banned Christmas and commercial lighting altogether. Politicians called for a national gasoline rationing program. President Nixon asked gasoline retailers to voluntarily stop selling gasoline on Saturday nights and Sundays, causing massively long lines of motorists wanting to fill up their cars while they still could. So this supply shock caused not only price inflation but also economic hardship, and that is the definition of stagflation.

But beyond supply shocks, we also have a second cause of stagflation, and that is economic mismanagement at a time of big money printing. If an economy is struggling, oftentimes central banks will print a lot of money to try and stimulate economic growth. The thing is, adding more dollars to the system is inflationary, and if inflation continues for a sustained period, people start getting used to it and they come to expect it.

In Zimbabwe's hyperinflation crisis, Mugabe kept printing money, and at worst, store owners were raising prices up to three times per day because of expected inflation. They weren't getting official inflation statistics three times per day; they just expected inflation to continue to rise. And what this psychological inflation expectation causes is prices to keep rising, citizens to keep spending their money as soon as they get it, and inflation becomes a self-fulfilling prophecy.

Inflation stays high irrespective of unemployment or economic output. This was again observed through the 1970s. The Vietnam War was soaking up vast amounts of money. Plus, in his quest to get re-elected, President Nixon greatly expanded social security. But once the U.S. dollar finally abandoned its link to gold in 1971, the U.S. was free to print money as they liked to help pay for all this. The M1 money supply grew from 228 billion to 249 billion between December 1971 and December 1972, and M2, which measures retail savings and small deposits, grew even more, from 710 billion to 802 billion by the end of 1972.

So the expansion of the money supply was there, but what about the mismanagement? Well, at roughly the same time, Nixon implemented both wage and price controls to try and curb inflation, which actually did work initially. But it came at a cost because the controls produced food shortages. Meat disappeared from grocery stores, and farmers were so fed up they would resort to drowning their chickens rather than selling them at a loss. That's not good for the economy.

But even worse was that once the price controls were eventually removed, that then caused a catch-up period a few years later where businesses raised prices sharply to try and make up for lost time, which again spiked inflation. But yes, excessive money printing as well as poor economic decision-making can also cause stagnation on top of just supply shocks.

Now, that was quite a long explanation. You might ask, why did I go into so much detail there? Well, it's because, as you might have already clued in on, we're also seeing a very similar situation now. We've got the supply shock in oil and gas, we've got other supply constraints from the global supply chain, and we've just seen a period of huge money printing. And the result is red-hot inflation.

But right now, the economy is worsening, and someone that's been warning us this whole time has been Ray Dalio. Are we close to having stagflation? We are, instinctively we are. You have a stagnant economy. Stagnant essentially means growth is reduced, right? And with high inflation, and that happens through this monetary situation that I'm describing, in which the central bank tries to deal with a middle course. In other words, what does the central bank want? Not too high inflation and not too low growth.

And so, when there's a lot of debt—because one man's debts are another man's assets—it becomes a very difficult balancing act. And that is when you have stagflation when you produce it. So just like in the late 60s, we spent a lot of money on the Vietnam War and social programs and so on. We wrote too many checks relative to the money we had in the bank, which was gold at the time. In 1971, the devaluation, then they print a lot of money into that stagnation.

So stagflation is the middle course when there are two different groups. Just like the 1970s, today we've got high inflation and economic weakness. Now, the difficult thing for the Federal Reserve is their solutions for each of these problems are contradictory. So for the economic weakness, the Fed would love to print money and lower interest rates, but for the inflation, the Fed needs to subtract money and raise rates.

So how do they tackle both at the same time? Well, they can't. And what Ray's saying is what's likely going to happen is the Fed will likely try and plot their way as best as they can through the middle of these two problems, which will likely cause stagflation. A period where not enough gets done to kill inflation, like what Paul Volcker did back in the 70s, and not enough gets done to substantially improve the economy.

When you're stuck with two trade-offs: too much inflation or you're stuck with too much economic weakness, then you navigate through the middle, and that means something like stagflation. And I think the political and the wealth gap issues and so on create a set of circumstances that's not easy to get out of because everybody needs more money. Taxation is the way to do it normally, but it's taking money away from somebody, whoever it is.

The one easy thing throughout history that's always been done is the printing of money because nobody even pays much attention to where the wealth is coming from. This clip is interesting because Ray touches more on the political struggle that also ties into the situation, which just adds another layer of complexity, as you can imagine.

Raising rates and subtracting money in large quantities at a time where citizens are already struggling to make ends meet is a hugely unpopular thing to do. And Ray has said in the past that he doubts there is enough political willpower in this day and age to decisively raise rates in order to stop inflation. And if that's the case, and you can probably argue we've seen a bit of that already, and that simply adds to the probability of stagflation.

For example, Paul Volcker caused a nasty recession in the early 80s when he hiked the Fed funds rate to 20 percent. That hurt people a lot; it did significantly reduce the inflation rate and killed the stagflation scene throughout the 1970s. But he didn't have a whole lot of friends at the time. Ray posted in the footnotes of one of his recent LinkedIn posts that, “while Paul Volcker’s bone-crushing tightening was followed by an improvement in conditions in the 1980s, a) it took a rise in real short rates to 8.4 percent and an economic dive that took the unemployment rate to 10.8 percent to reduce the spending to lower inflation, and b) it led foreign countries’ debtors to be squeezed and to cut spending a lot, putting them into 10-year-long depressions.”

In other words, inflation was reduced by people and companies being painfully squeezed and reducing spending. The question is, will there be the political willpower to do a similar thing today? Ray argues probably not. And I mean, it took half a year for the Fed to even acknowledge that inflation existed while they were flogging the printer. So it's definitely an interesting factor to consider.

And if the political willpower isn't there, it only adds to the stagflation argument. Not enough gets done to solve either of the two problems, and we get caught in the middle for a long time. Jay Powell has a balancing act that he has to achieve in order to try to ward off a recession.

Right? So think about it this way: how does he literally fight inflation? Because everybody says tight money policies. Well, the way that happens is you get people to spend less by taking money and credit away from them. Right? So he will reduce the amount of money and credit that's available. The Federal Reserve is going to sell 1.1 trillion dollars of debt that it has, debt assets buys, and then they're going to raise interest rates.

So they create a squeeze that reduces demand at the same time as people don't have enough money because inflation is higher and their buying power is less. That's right, because inflation is high, the buying power is less. And then what that act is is to reduce buying power again to reduce inflation. But it comes at a big cost, and that is stagflation.

So in this scenario, if the Fed really wants to kill inflation, the method for doing so might be so painful that they simply won't be able to do it to people. If that is indeed the case, then in Ray's eyes, it's highly likely that we're in for a period of stagflation: persistent inflation, economic struggles, and thus nothing the Fed can do that solves both simultaneously.

But with that said, do you think Ray is right? Will we see stagflation over the next few years, or will the Fed be decisive and keep raising rates until they hit their two percent inflation rate? Definitely let me know what you think down in the comment section below. Leave a like on the video if you did find it useful or if you enjoyed it. Subscribe to the channel if you'd like to see more. But guys, that will just about do it for today. Thanks very much for watching. I'll see you guys in the next video.