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Is the U.S. Stagflation Nightmare on its Way Back?

By , Money Morning •

Stagflation is an economic phenomenon so terrifying economists previously thought of it as only theory that could never materialize.

Then the 1970s came with wage and price controls, an oil embargo, and one of the worst economies since the Great Depression.

Now the roots of stagflation are creeping into the U.S. economy once again.

So how does stagflation occur? More importantly - can we avoid it?

Let's take a look.

What is Stagflation?

Stagflation exists, like it did in the 1970s, when an economy experiences slow growth, high unemployment and high inflation.

This is a nightmare scenario where consumers have less and less money to spend, the money they do have is less valuable, and there is no hope for economic growth.

Keynesian economists who adhere to the economic concept of the Phillips curve previously thought stagflation was impossible. The Philips curve shows the inverse relationship between unemployment and inflation, suggesting that when unemployment is low inflation is high and vice-versa. It denies stagflation by making high unemployment and high inflation mutually exclusive.

After the 1970s, many scholars adjusted their thinking.

"The belief that you can't have inflation and high unemployment is nonsense; we had 25% inflation in the U.K. in 1975, in the middle of a recession," said Money Morning Global Investment Strategist Martin Hutchinson.

Stagflation not only hit Europe, but the U.S. as well.

U.S. Stagflation in the 1970s

In the late 1960s and 1970s, the U.S. Federal Reserve lowered interest rates and significantly increased the money supply in a futile attempt to reach full employment (sound a little familiar?).

This led to increased demand for goods and services, and consumer prices rose. Wages climbed at first, but eventually they could not keep up with inflation and as a result unemployment increased.

In the three years leading up to 1970, unemployment averaged 3.6% and gross domestic product (GDP) averaged 3.5%. By 1970 unemployment was 4.9% and GDP only grew 0.2%.

That same year inflation was 5.5%, which led President Nixon to impose price and wage controls in August 1971 to curb inflation.

That was also when Nixon took the United States off the gold standard. This devalued the dollar, on which the price of oil was based, meaning oil producers received less income for the same price.

In response, the Organization of the Petroleum Exporting Countries (OPEC) slowly started raising the cost of a barrel of oil.

What ignited inflation was OPEC's oil embargo of 1973-1974. The embargo was in response to aid that the U.S. and other countries provided to Israel during the Yom Kippur War. Oil prices immediately quadrupled, going from $3 a barrel to $12 and would peak at $38 ($104 today) later in the decade.

As oil prices rose, so did the cost to transport goods. Eventually everything Americans bought cost more.

Nixon's price controls had failed and in 1974 inflation hit 12.2%. To make matters worse for U.S. households, the NYSE lost 45% of its value during 1973-1974.

With the economy mired in a recession - GDP contracted 0.6% in 1974 and 0.2% in 1975 - the Fed again increased the monetary supply to boost output and growth. Unfortunately, the Fed caused even higher inflation and higher unemployment.

In May 1975, both unemployment and inflation were above 9% and stagflation had become a reality. Inflation would peak around 14%, and after 1974 unemployment averaged 7.9% for the rest of the decade.

After a few years of expansion to end the 1970s, GDP contracted again in 1980 and the U.S. endured a severe recession in 1981-1982. While economists blame the oil embargo as the main factor for stagflation in the U.S., it wasn't until expansive monetary policy was reversed and interest rates were raised that the country got out of the atrocious cycle of stagflation.

Now it appears we are headed down this very same path forty years later.

Stagflation Warning Signs

When you look at what happened in the first half of the 1970s, the similarity between then and now is frightening.

Our economy has stalled, last quarter's GDP was revised down to 1.25% and many economists expect the U.S. to head into a recession next year. Unemployment has been stuck above 8% for more than three years and has only been kept down by a decline in the labor force.

The Fed likes to argue that inflation has remained low, but it seems that trend is starting to change.

Just look at data from the American Institute for Economic Research (AIER), which "backs out" the big-ticket items that are infrequently purchased by consumers. It concentrates instead on "everyday prices" - the regularly purchased items that matter most to working Americans.

Its Everyday Price Index (EPI) rose 1.8% in August compared to the U.S. Bureau of Labor Statistics Consumer Price Index (CPI) which only rose 0.6% in August. Year-to-date the EPI has increased 4.2%, three times the 1.4% increase in the seasonally-adjusted CPI.

And although the oil embargo currently enacted by Iran is not as catastrophic as OPEC's 1973 embargo, there are still numerous catalysts that could send oil soaring. Escalating tensions in Iran, overestimated supplies, and increased worldwide demand for oil could send the price above $150 a barrel next year.

Editors Note: Consumer prices aren’t all that are inflated – [ppopup id="70925"]check out this report on what the Dow is really worth.[/ppopup]

What You Should Do Now

In order to avoid stagflation and another lost decade, the Fed needs to stop increasing the monetary supply and examine how previous Fed Chairman Paul Volcker raised interest rates from 1979-83 in order to end stagflation.

Until you see the Fed make any adjustments, prepare yourself wisely.

Investors can avoid the perils of stagflation and deal with the uncertainties ahead by following the strategy of Money Morning's Global Investing Strategist Martin Hutchinson.

His plan allows you to not only fight inflation by protecting your wealth but generate great returns by focusing on companies that offer consistent streams of income. Plus he has multiple techniques that enable you to maximize your profit in a risk-free way.

With 30 years of investing experience and a Harvard MBA, Hutchinson knows how to handle this unpredictable market. If you want to find out what's in his portfolio and make sure your nest egg continues to grow in value, click here.

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