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Stagflation is the toxic brew of “stagnation,” an economy that is barely growing in real terms, and “inflation,” with consumer prices rising relentlessly nonetheless.
It’s sort of the worst of all worlds, especially for savers and investors. The phrase was coined in the 1970s, when it seemed to be almost a permanent state of affairs. The people who suffered most were savers, especially retirees, who kept their money in supposedly safe things like certificates of deposit and Treasury bonds. Prices rose by more than the rate of interest: So in real, purchasing power terms you were going backward.
Before taxes, too.
These were not good times.
Could this happen again?
The bad news is: It may be already.
Headlines made much of the latest economic data, which came out on Thursday. They noted that real, inflation-adjusted growth in gross domestic product was just 1.1% in the first three months of the year, slowing sharply from the 2.6% rate in the last three months of 2022. That was well below economists’ forecasts, which were closer to 2%.
Meanwhile, although inflation fell in the quarter, the measure preferred by the U.S. Department of Commerce was still 4.2%, stubbornly high. The markets are now expecting Fed chairman Jerome Powell to hike interest rates yet again next week, by a further quarter-point, as he tries to kill inflation for good.
But a closer look at the latest data is even more worrying. That 1.1% growth in the first quarter? It was effectively all government. The private sector barely grew at all: By just 0.3% on an annualized basis. It was government spending, rising at 4.7% above inflation, that kept things humming. Federal spending rose by nearly 8% above inflation on an annualized basis.
Maybe this doesn’t matter—government spending is real spending, after all—or maybe it does. But it is hardly a positive sign about the underlying strength of the economy. Even while inflation remains high.
The good—or bad—news is that nobody actually knows whether we will end up in stagflation. Economic forecasts are scarcely worth the paper they are printed on, and are of almost no use for anyone managing their money.
I well remember early 2008, when most Wall Street economists were insisting America would completely avoid a recession. Not only did the country then plunge into the biggest financial meltdown since the Great Depression, but later data showed that while the economists were saying there wouldn’t be a recession America was already in one.
But if you are a retiree, you hold a lot of your money in bonds, and you are worried about stagflation, you really don’t need an economic forecast anyway.
There is a simple way to protect against inflation: inflation-protected U.S. Treasury bonds, which continue to be under owned. I actually don’t really understand why anyone would prefer regular Treasurys to inflation-protected ones.
Like most people I have my own portfolio in stocks, bonds and commodities, and my bond portfolio is entirely invested in TIPS: Not because I know what is going to happen to inflation, but so I don’t have to.
TIPS did not even exist in the 1970s. They were created in the aftermath, first in Europe, and then, later, in the U.S. So far they have never been tested during the kind of conditions—stagflation—for which they were expressly designed.
The technical details of TIPS are like the inner workings of a fine Swiss watch: Mind-bogglingly complex, and largely irrelevant to anyone who just wants to tell the time. The bottom line for us is that TIPS bonds pay a rate of interest that is based on the inflation rate. If inflation goes up, your interest payment goes up. If it goes down, your interest payment goes down. At the moment, TIPS bonds are priced to pay out inflation plus about 1.2% to 1.5%, per year, for the life of the bond. The longer term TIPS bonds tend to pay more: For example the bonds that won’t mature until 2049 are priced to pay you inflation plus 1.53%, per year, until then. If you buy the bond and hold it until maturity you are guaranteed to beat inflation by 1.53% a year between now and then. And that’s true no matter what happens to inflation.
I may sound like a broken record on TIPS but I think they are generally under owned, especially by retirees. Partly I think that’s because most people on Wall Street, and in the media for that matter, are too young to remember the 1970s with any clarity, if at all.
Some of the economic numbers I watch closely are called the “break-even rates.” (More Swiss watch stuff.) These compare the interest rates on regular Treasury bonds and TIPS bonds. They tell you, in effect, how low inflation has to fall before the regular Treasury bonds are a better deal than the TIPS bonds. At the moment the five-year break-even rate is just 2.3%. That’s because the five-year regular Treasury bond will pay you 3.6% a year, regardless of inflation, while the five-year TIPS bond will pay you 1.3% plus inflation. The difference is 2.3%: So you would only be better off in the regular Treasury bonds if inflation averages 2.3%, or less, over the next five years.
That bet looks pretty crazy to me. But more important, I don’t want to bet anyway. My bonds aren’t a gamble on inflation: They are there to provide security and stability to my portfolio.
Bottom line: The simplest investment to protect retirees against stagflation is TIPS bonds. And stagflation may already be here.
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