Worrying Signs That the Economy is Drifting Towards Stagflation

You may have heard and been familiar with Inflation. But a term you may not be too familiar with is Stagflation, but it is a term you are likely to hear a lot more of in the coming months. So what is it? Firstly, Inflation is the rate of the increase in the prices of goods and services within an economy. This can be from an overall demand increase or a shock in supply. It often occurs when an additional stimulus is provided, as consumers and businesses have more capital to distribute - increasing demand. This is what we have seen over the past 18 months, with government furlough schemes and quantitative easing by central banks.

Low rates of inflation can benefit an economy as the increase in money supply erodes the value of debts due to the devaluation of a particular currency that comes with printing more cash. This debt erosion allows businesses and consumers to take on more credit, using that additional amount to build infrastructure and expand services. This is one of the reasons why most central bank's target a 2% rate of inflation.

However, due to lockdown restrictions over the 18 months, the overall business climate has come to a halt. It is only now that many businesses have reopened. The uncertainty around the future of a particular countries' economy has reduced borrowing and lending credit for both consumers and businesses. Many banks and financial institutions have made credit less available causing a chain effect across the whole economy.

Therefore, the increased money supply but lack of credit available creates inflation, but without the economic growth to balance the economy. This is known as Stagflation - where the cost of production rises whilst the economy slows.

Here are some common causes of Stagflation, such as:

• Higher oil prices

• Higher food prices

• Currency devaluation

• Higher taxes

• Rises in unemployment rates

When the productivity of an economy is reduced by some of these factors, costs continue to rise, with supply shocks along the way, as we have seen with the recent oil crises. This will have a ripple effect across the economy due to the reliance on oil in today's climate.

Although it is not to be feared in the current conditions, it could be in the coming future. The fear of inflation rising uncontrollably with a slowdown in economic growth could lead to economic depression. The balance between providing stimulus to support an economy, but also preventing inflation from spiralling out of control will be determined by central banks. The steps they take next will be the biggest impact on what happens to the world economy next.

A solution to keep the balance could be reducing a country's reliance on oil, as it is a major cause of stagflation. However, the recent crisis shows that many major economies are not ready to make the transition to a fossil-fuel-free climate. Especially with the rising concern over climate change, this is already in place as a long-term move anyway.

The likely solution to stagflation will likely be around interest rates. This can be used for a rapid change in the economy. In a short amount of time, inflation can be reduced with an increase in interest rates. A change to interest rates is what investors are expecting from major central banks next.

We asked an Analyst from YLDFX brokerage to comment on the expected rise in interest rates: "At this moment in time, it is unclear when exactly central banks will combat inflation by raising interest rates. The Federal Reserve's Chairman Jerome Powell has recently advised they are not looking at raising rates until 2022. They remain focused on supporting the economy through continued stimulus. However, it will become an issue if inflation continues to rise further and for a sustained period. Many investors are expecting central banks to be forced to raise rates to prevent hyperinflation and currency devaluation sooner than they may wish."

"At the moment the US Dollar is looking stronger compared to the other major pairs. We are yet to see a full recovery back to the highs pre-covid, but based on the current conditions, overall market sentiment is bullish. The expectancy for a rise in the interest rate of the Dollar has created a trending market. The price most recently broke above a previous high, showing strong momentum to the upside. The high hit was the 94.50 level and since we have pulled back to the 93.73 level, bouncing off the previous high. Could we see the price of the Dollar hold this level and run higher to the 94.74 level or are we going to see a drop further?

Although we may see retracements along the way, we would be expecting the dollar to continue to rise until we see any changes in overall sentiment as both retail traders and institutions bet on this rise in interest rates."