What to know about rising inflation and slowing growth.
by Fidelity Viewpoints
Key takeaways
- Inflation is rising while economic growth shows signs of slowing.
- High inflation and slow growth is an undesirable—but also uncommon—combination.
- Most of the factors that have created prolonged high inflation and slow growth in the past are not present in today's economy.
- Stocks may continue to deliver attractive returns despite inflation.
The numbers confirm what you know if you've bought almost anything lately: Inflation is back. The consumer price index has risen 5.4% over the last 12 months, the highest increase in 13 years. That partly reflects supply chain and production constraints, but also the strength of the recovery from the uniquely short and deep COVID-19-related recession.
However, some indicators suggest the recovery may not be as strong as hoped. Earlier in 2021, forecasts for US GDP growth in 2021 were revised up from 5% to 8%, but since then, they've come back down to around 5%. That's raising questions about whether the future may hold an unusual combination of slow growth and rising prices, known as stagflation.
Conventional economic thinking holds that strong growth leads to rapid price increases, while weak growth usually comes with low inflation. Indeed, the 20th century's most influential economic thinker, John Maynard Keynes, claimed that inflation and a stagnant or contracting economy were mutually exclusive.
But saying that something can't happen doesn't prevent it from happening. The last time the US endured a long run of high inflation, it also suffered through several recessions and weak recoveries from those downturns. That bout of stagflation persisted throughout the 1970s with profound social and political as well as economic consequences. Since the impossible already happened once, could it happen again?
Back to the 1970s?
While 2021 has at times felt like the 1970s, a repeat of '70s-style stagflation is far from certain, says Bradford Pineault of Fidelity's Capital Markets Group. "With inflation rising, a lot of people's expectations are gravitating towards the most negative outlook," he says. "Instead, we believe that while things aren't perfect, they're hardly bad and the economy is expanding."
Even with growth expectations being revised back down closer to 5%, the current recovery is still far stronger than the one that followed the global financial crisis and the economy's strongest performance since 1984. "That's slower than some had predicted but it's not stagnant by historical standards," says Pineault.
Pineault expects that as growth slows, inflation will also slow to around the Federal Reserve's long-term target rate of 2.0%. The bond market, which often offers clues about the future, appears to agree. The breakeven inflation rate is a market-based measure of expected inflation that reflects the difference between the yield of a nominal Treasury bond and an inflation-linked Treasury bond. Current breakeven rates suggest that inflation will gradually float down to around 2.5% over the next several years.
What's different this time
Two big reasons why '70s-style stagflation appears less likely today are energy and labor. In the 1970s, the US was an oil importer and the economy was still based on energy-intensive manufacturing work performed by unionized workers. That left the US acutely vulnerable to higher oil prices after the Organization of Petroleum Exporting Countries (OPEC) cut off shipments to the US during the 1973 war between Israel and its neighbors. Meanwhile, powerful private-sector unions won cost of living increases for their members, driving wage inflation.
More than 40 years later, the US can produce as much oil as it needs. While the price of oil has been volatile over the past year, the chance of a 1970s-style oil shock appears minimal according to Fidelity's Asset Allocation Research Team, despite the federal government's warning of sharply higher heating costs this winter.
Private sector unions and manufacturing also play a far smaller role in the US economy. Instead of unionized labor, work is increasingly being done by robots and software, which are disinflationary or even deflationary. Indeed, widespread wage stagnation since the 1980s has been a major reason for both low inflation and a widening income gap between the wealthiest Americans and the rest of the population.
Beware policy error
While energy and labor costs are unlikely to brew a new batch of stagflation, there is another factor to consider: the potential that policymakers' decisions could have unintended consequences.
In the early 1970s, the economy was beginning to feel the inflationary effects of massive increases in federal government spending on the Vietnam War and the Great Society social programs of President Lyndon Johnson. Johnson's successor, Richard Nixon, who once said of economic policymakers, "we're all Keynesians now," sought to tame that inflation with interventionist policies including controls on wages and prices. Those policies were counterproductive, says Pineault, and on top of the oil price shock and the devaluation of the dollar helped create a vicious cycle of slowing growth and rising prices.
Since 1982, when Federal Reserve Chairman Paul Volcker defeated stagflation by raising interest rates to double-digit levels, even at the cost of a severe recession, the Fed has focused on controlling inflation. If the Fed were to choose instead to keep monetary policy loose and fiscal policies were to introduce inflationary pressures into the economy, it's not impossible that the return of inflation could prove less temporary than hoped for.
Investing ideas for a stagflationary environment
Fidelity sector strategist Denise Chisholm has looked at previous periods of stagflation and says history provides an ambiguous guide for investing when growth is weak and inflation high. Defensive stock sectors such as consumer staples and health care have historically performed well in recessions but less so when growth has been merely slow. Similarly, while technology has benefited from low inflation, it hasn't done badly when inflation has risen. That history suggests that the best approach is to be diversified and remember that inflation by itself is not necessarily a bad thing for stocks.
As Pineault says, "The price of a stock reflects how profitable a company is and if you have inflation, revenue can be higher. That means stocks typically are the most effective hedge against inflation."
With that in mind, this may be a good time to put some Doobie Brothers or Captain and Tennille on the 8-track player and review your asset allocation.
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