Phillips Curve Foundation and 1970s Crisis

• 1958: New Zealand economist A. William Phillips proposed Phillips Curve model
  • Theory: price inflation and unemployment inversely related
  • Low unemployment → scarce labor → higher wages → higher prices
  • High unemployment → slower economic activity → cooler inflation
• 1970s: Phillips Curve faced existential crisis
  • US experienced decade of both high unemployment AND high inflation
  • Phenomenon dubbed "stagflation" (stagnant + inflation)

Stagflation Definition and Characteristics

• No technical definition exists for stagflation
• Broad characteristics:
  • Rapidly rising prices
  • Slowing economic output
  • High unemployment
• Different from recession:
  • Recession: economy contracts for 2+ consecutive quarters
  • Stagflation: economy may continue expanding but at very slow/flat rate
  • Rapidly rising prices painful for businesses/consumers despite slow growth
• Stagflation abnormal and rare vs recessions being natural economic cycle part

Causes of Stagflation

• Two main ingredients:

Supply Shocks

• Exogenous forces disrupting supply side of economy
• Causes: natural disasters, war, geopolitical issues
• Impact on important commodities (crops, metals, oil) → broad-based inflation
• 1973 example: Arab OPEC oil embargo against US for Israel support during Yom Kippur War
  • Oil prices quadrupled
  • Prices rose further toward 1980s

Economic Policy Errors

• Disruptive government policies + rapid money supply increase
• Disruptive policies: excess taxes, price controls, regulations hampering profitability/productivity
• Central banks pursuing expansionary policy during existing price increases
• 1970s example: Federal Reserve maintained low interest rates despite booming 1960s
  • Caused inflation to take off when supply shock hit

Self-Fulfilling Inflation Cycle

• Inflation hard to cool down even if supply shocks subside
• Rising prices create self-fulfilling prophecy
• Consumers/businesses/investors expect price rises → adjust behaviors accordingly
• Demand higher wages, hike prices → ensure inflation continues

Current 2022 Parallels to 1970s

• High inflation after decade+ of monetary stimulus
• Oil experiencing supply-side shock
• Troubling similarities causing stagflation concerns in headlines

Policy Dilemma and Historical Solutions

• Policymakers face trade-off between inflation and unemployment
• Two lose-lose options:
  • Raise interest rates → contract money supply, discourage spending → slow already slow economy
  • Cut interest rates → stimulate economy → cause inflationary spiral
• 1970s solution: US hiked interest rates to ~20%
  • Shocked system to get inflation under control
  • Brought on painful recession but ended stagflation
• Current concern: Federal Reserve rates far from 20% level needed historically

Key Differences Between 1970s and 2022

Oil Dependency Reduction

• According to Horizon Investments:
  • 2022: 0.43 barrels oil per $1,000 global GDP
  • 1973: 1 full barrel per $1,000 global GDP
  • Oil intensity dropped 57% since 1970s

Smaller Oil Price Increases

• 2022: Oil prices almost double from pre-pandemic levels
• But only marginally higher than 2014 levels
• 1970s: Prices more than tripled early in stagflation period

Consumer Budget Composition Changes

• Fuel and electricity represent smaller share of household budgets vs 1970s
• Disposable income dedicated to debt payments has fallen
• Household budgets more resilient than 1970s

Central Bank Credibility

• Central banks have better reputation for controlling inflation than 1970s
• Longer track record for keeping inflation low
• Markets believe central banks will pursue aggressive rate hikes
• May prompt recession but should help stave off stagflation period

Current Assessment and Outlook

• Only seen one aspect of stagflation so far: inflation
• Unemployment remains very low in North America
• Hiking rates before unemployment deteriorates should help avoid worst case
• Recession risks high but recessions typically last under 1 year
• Better than decade of stagflation requiring recession anyway
• Developing countries likely to experience particular hardship
• Many hurdles ahead addressing root causes of inflationary pressures
• Claims of current stagflation or bound to repeat 1970s mistakes are misleading

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