The upcoming economic crisis? | Stagflation explained

There is a really ugly word that is beginning to be thrown around for the first time in nearly 50 years. The last time the US economy experienced the devastating impacts of this word was way back in the 1970s, a period of time when inflation had a staggering 12 percent, and due to oil rationing, Americans waited on long lines just to get gas for their cars. The 1970s in the U.S. was a period of what is referred to as stagflation.

In this video, we are going to talk about what stagflation is, why its effects are devastating for an economy, and why there's rising concern that stagflation is going to return soon. But first, make sure to hit the like button and subscribe to the Investor Center if you aren't already, because a ton of research goes into making these videos, and it helps out the channel a ton. Now let's get into the video.

I think it's important to first explain what stagflation really is. The answer to what stagflation actually is lies in the word itself. Let's separate the word into two parts: stag and inflation. The first part, stag, refers to a stagnant economy. So, in a stagnant economy, economic growth is slow or even negative, and the unemployment rate is high. Obviously, a stagnant economy is a bad thing just by itself, but it's made even worse when you throw the second part of the word into the mix.

The inflation part of the word stagflation refers to a period of high inflation. Now, obviously, any of these two scenarios are bad on their own - a stagnant economy or high inflation. But when you combine the two together, you get stagflation: a period of a weak economy and persistently high inflation. Now, the last time we saw a period of extended stagflation here in the United States was back in the 1970s, a period of time where pretty much everyone watching this video either a) has not been born yet or b) was very young.

Right now, in the year 2022, it seems like the economy is just experiencing deflation part of stagflation. There is no arguing that inflation is currently very high. The most recent inflation reading was around 7.5 percent, well above the long-term “normal” rate of only around two percent. However, I think it's worth pointing out that inflation right now surely feels well above 7.5 percent for many people. Rents are up anywhere between 15 to 40 percent in some areas, vehicle prices are skyrocketing, and food prices are experiencing double-digit increases.

However, with that being said, the economy still appears to be very strong. In my job as an investment analyst for a large investment fund, I talk to a lot of business leaders to understand what is going on with their business. Nearly every single one I talk to says that demand for their products is incredibly strong and is showing no signs of weakening. However, the worry many investors have is that the economy will start to slow as interest rates increase. If this happens, and inflation remains high, we may soon be entering a period of stagflation.

Let's listen to well-respected economist Ed Yardeni explain what he is seeing in the economy. "It's a word that a lot of people don't like to use when you talk about all this," Ed Yardeni's the president of Yardeni Research, "and it's the S word - the stagflation word. Are you really worried about that today?"

"I think we're in it. Before the war, we had a lot of data suggesting that we were experiencing an inflationary boom. Inflation was high, but at the same time, I think there was a widespread consensus, and I agreed with it, that we'd see peak inflation maybe by March or April, and then we would get back down - not to two percent, but maybe down to three to four percent. But now, as a result of the war and what's happened with commodity prices, we're clearly looking at higher inflation, and peak inflation isn't going to be for a while. And then, the concerns, of course, is that we get more wage-price spiral inflation. It's getting to be a little bit of a déjà vu with the 1970s all over again. Since the war, I think stagflation is the scenario that's probably most descriptive of what we're starting to see and what we'll see in the next several months, which is higher inflation than we thought before the war and slower economic growth."

"That would be Jay Powell's worst nightmare," he continues. "Yes and no. In some ways, he's gotten a reprieve here because I think he can stay behind the curve, well behind the curve of inflation, and argue that there are extremely complex geopolitical circumstances which raise a lot of uncertainty. And so, the Fed, I think, will continue – will raise interest rates, but we'll do it very, very gradually and not just use the excuse. It's a good excuse; there are a lot of geopolitical uncertainties. This is not just a short-term geopolitical flare-up. As one of your panelists said, this is something much more concerning."

"Sure, but then how are they going to deal with inflation if inflation's going to remain elevated for many months ahead?" he adds. "Therein lies the problem. He can't be as cautious or is, you know, reticent to raise rates because of these geopolitical concerns. Now, if inflation's going to be worse than he thought, well, the last thing the U.S. needs right now is a recession. I mean, we need to have a relatively strong economy and get through this geopolitical mess so that we can be stronger coming out of this mess."

"But I think that Powell will use this as an excuse to explain why the Fed isn't taking a tougher stance. Look, I don't think there's much the Fed can do about inflation other than a Volcker 2.0. I mean, Volcker demonstrated that the only tool that the Fed really has to bring inflation down is to let interest rates rise to whatever level it takes to cause a recession, which then breaks the back of inflation. I don't see Volcker 2.0 coming out of this Fed. Let's face it; stagflation is scary. With inflation soaring to seven, eight, maybe even a whopping nine percent, a global crisis, and top firms predicting that stock returns will be under 5% until 2035, the threat of stagflation is real.

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I think to truly understand stagflation, its causes, and the impact it can have on an economy, it's worth examining stagflation in the 1970s here in the United States. Stagflation occurred during the decade as a result of monetary and fiscal policies and an oil embargo. It's interesting to note that before the 1970s, many economists thought that stagflation wasn't even possible. The reason behind this was that they reasoned unemployment rates and inflation rates moved in opposite directions, meaning if unemployment was rising, inflation couldn't also be rising at the same time. They believed that inflation was tolerable because it meant the economy was growing and unemployment would be at low levels.

Their general belief was that an increase in the demand for goods drives up prices, which in turn encourages firms to expand and hire additional employees, creating additional demand throughout the economy. However, as the Great Inflation period of the 1970s ultimately proved, stagflation is real, and it can have a devastating effect on the economy.

There were four defining characteristics of the U.S. economy in the 1970s: high oil prices, high inflation, high unemployment, and recession. In November 1979, the price of oil surpassed 100 per barrel when adjusted for inflation and went on to peak at 125 just a few short months later. It would take nearly three decades for that peak to be reached again. Inflation was also incredibly high by U.S. standards, topping out at 13.5 percent in the year 1980. Unemployment was also consistently high, frequently above seven percent, and even hitting 8.5 percent in 1975.

The economic impact lasted long into the early 1980s, with unemployment nearly hitting 10 percent in the early 1980s. In order to "break the back of inflation," the chair of the Federal Reserve at the time, Paul Volcker, had to take some pretty drastic steps. Interest rates rose, and this sent the U.S. economy into a nasty recession. However, over time, the economy stabilized, and inflation disappeared. This set the country up for a booming economic period of the mid to late 1980s.

Right now, in the year 2022, there is no doubt that we are in a period of inflation. Costs for goods and services are going up across the board for nearly everything: shelter, food, transportation - the list goes on and on. There's no arguing about that. The main point of debate right now is how long this inflation will last and whether we'll stay at these elevated levels for an extended period of time.

One interesting data point is worth mentioning that really shows just how quickly prices for goods have risen. I saw a statistic recently that a cart of groceries purchased at Walmart has increased in cost more in the last six months than it did for the entire 10-year period from 2011-2021. So, let's revisit the definition of the word stagflation again. Right now, we definitely have the inflation part; we can put a check there. However, on most measures, the economy is still super strong.

The concern that some people have is that as interest rates rise, the economy will slow down, and if inflation still remains persistently high, the economy will slip into the dreaded stagflation. One area that increasing interest rates has already had an impact on is housing. Check out this crazy statistic: the average interest rate on a 30-year fixed mortgage here in the United States was around 2.7 percent in February of 2021. Now, in just a little over a year, the average rate has increased to around 4.7 percent. While interest rates are still low by historical standards, as interest rates rise, this leaves new homeowners with less money to spend on other things.

Let me show you what I mean. Let's assume someone's buying a $350,000 house with a 20% down payment at a 2.7% interest rate on a 30-year mortgage. That equates to a mortgage payment of $1,136 a month. Now, if we do the math with the same variables but instead bump that interest rate on the mortgage up to 4.7%, the monthly mortgage payment increases to $1,452. This means that this new homeowner is paying an extra $316 to cover their mortgage payment, meaning they have less money they can put back into the economy through going out to eat, traveling, or buying goods like furniture, cars, or clothes. This is just one example of the impact rising interest rates have on an economy.

So, this brings us to the question I want to answer in this video: given the current economic environment, how should we be investing? To answer this, I turn to Warren Buffett, who at the age of 91 has lived through his fair share of inflation, stagflation, deflation - you name it, he's probably lived through it. I made an entire video on the topic that you can check out here, with nearly 1 million views. It must have been a pretty relevant topic given what's going on in the world today.

Now, I just want to take a moment to summarize some of the main points from that video because the lessons from Warren Buffett are still extremely relevant during a period of stagflation. The absolute worst possible investment to hold during a period of high inflation is cash. Money that you have sitting in a bank account is losing its value in “real” terms as inflation eats away at its purchasing power.

This brings me to the next important thing to keep in mind. We as investors should be thinking about our investment returns and what is referred to as real returns. This means that if our portfolio returned 10 percent in a year, but inflation was 7 percent, that means our real return was only 3 percent. Our goal as investors should be to maximize our return in real terms. Since the return on cash is 0 percent, it's very hard to combat the impacts of inflation while holding large amounts of cash in your portfolio.

So, there you have it. Make sure to like this video and subscribe to the Investor Center because it's my goal to make you a better investor by studying the world's greatest investors. Thanks again so much for watching, and looking forward to seeing you all again shortly.