Stagflation Dead Ahead
This is how you go from bad to worse.
As expected, the Fed hiked rates 0.75% and signalled any end to the raises is “very premature.”
Long story short, rates are going higher.
Higher rates alone would be economically survivable.
The combination of high interest rates combined without increased energy production is a recipe for stagflation.
Stagflation is the combination of a stagnant economy and high inflation.
Here’s why and what to do about it.
How The Fed Will Fail
The Fed is driving the economy towards a cliff.
The problems of dislocation and disruption are all getting accelerated by the Fed rate hikes.
Worst of all, they are doing what they think is right.
Theoretically, higher rates drive down lending, which reduces money supply, which should, in time, reduce inflation.
It is cutting inflation in many non-discretionary products and services.
But essentials could keep steadily increasing as more consumer dollars flow directly to them and discretionary income continues to slide.
Energy is the perfect example.
There must be an aggressive investment and build up of energy supply to avoid a stagflationary recession.
That’s because much of the energy demand is inelastic.
Or, in other words, it’s not price sensitive.
Sure, when gas prices are high, consumers take action by driving less, combining errands, or not driving at all if they don’t have to.
But they still have to drive. A lot.
According to the American Petroleum Institute (API), U.S. drivers consumed a combined 9.329 million barrels per day in 2018.
The average price of gas back then was $2.74 per gallon.
Now go ahead to 2022.
The price of gas is expected to average $4.05 per gallon for the year according to the Energy Information Administration.
The rise in price won’t do much according to the API.
They estimate the average daily consumption will be 8.9 million barrels per day.
That means prices are up 47% while consumption is only down less than 5%.
This is a textbook definition of inelastic demand.
There is a bit around the edges, but not much consumers can or will do about it.
And energy is behind much of the inflation.
It’s more than just gas prices.
Because every consumer segment is directly impacted by high energy prices.
Airl fares are up 42%.
Furnishings, tools, and everything produced in a factory that runs on electricity.
Higher energy prices mean higher costs for them.
Anything made internationally and must be shipped in, transported on a diesel locomotive, and then tricked to the store.
Energy prices get into everything.
And without more abundant and cheaper energy, inflation in the goods you demand will remain high.
Overall inflation will likely slow or reverse in non-discretionary goods and services like hotel prices (remember 2008, Vegas was a ghost town).
But the high energy prices will be baked into everything in a big way.
That’s why the Fed’s rate hikes will definitely slow economic activity, but will create an even worse problem.
Garbage In, Garbage Out
As mentioned above, stagflation is the combination of a stagnant economy and high inflation.
The ongoing inflation in essential things like energy (even if overall inflation is held down a bit from decline in non-discretionary goods and services) and reduced investment and consumer demand from higher interest rates is the perfect recipe for stagflation.
It was like this in the 1970s.
Despite what most history books say, it was more than just OPEC.
Price controls kept a lid on oil and energy production which led to shortages.
Environmental regulations, some of which were surely a net benefit as well, helped keep a lid on oil production too.
The end result was years of stagflation.
There wasn’t a change in this trajectory until the 1980s when energy production soared.
Until there is a change on the energy front, all investors should remain focused on the companies that can succeed and grow under these conditions.