Stagflation threatens to hit the U.S. as it did 50 years ago, economist Zandi says

Stagflation is arguably the dirtiest word in economics. It describes the dark brew of a stagnating economy and high inflation.

A British politician coined the word in the mid-1960s to describe the suffering of the U.K. economy. It aptly describes what the U.S. economy went through during much of the 1970s and early 1980s.

Soaring oil prices drove the stagflation of that time.

The OPEC cartel of oil-producing nations, mostly in the Middle East, flexed its collective muscles and embargoed oil exports in the early 1970s. Later in the decade, the Iranian revolution — which established the Islamic Republic that has ruled to this day — led to U.S. embassy workers being held hostage for months, severely disrupted global oil supplies, and sent oil prices skyward.

Higher oil prices have historically been the key source of stagflation. Inflation rises as we pay more at the pump for home heating, airfares, and everything that is moved by truck, from food to clothing. If we are putting more of our hard-earned dollars into our gas tank, we have less to spend on everything else. Consumer spending and the economy sputter.

Nothing gets under the skin of Americans more than paying more to fill their gas tanks. It is so irksome that they feel like they are paying more for most everything and will do so long into the future. Their expectations are that inflation will accelerate further, and they demand higher wages from employers to compensate. Businesses oblige, believing they can pass along their higher labor costs to their customers by raising prices for their wares. A dreaded wage-price spiral kicks in, and stagflation takes hold.

Half a century ago, during the early stages of that stagflation, the Federal Reserve made the mistake of doing little to short-circuit the wage-price spiral. This was partly because Fed officials didn’t understand the critical role of inflation expectations and partly because the Fed had been captured by then-President Richard Nixon. His friend Arthur Burns, who was chairman of the Fed, kept interest rates too low in an effort to juice up the economy in advance of the 1972 presidential election.

This ended badly.

To break the wage-price spiral, the Fed ultimately had to raise interest rates aggressively and push the economy into a long and severe recession. By the early 1980s, under then-Fed Chair Paul Volcker, unemployment had soared into the double digits.

Here we are a half-century later, and this history feels relevant.

The U.S. and Iran remain at odds, this time over Iran’s aspirations to become a nuclear power. Fortunately, we have dodged a bullet, at least for now. Oil prices jumped in the lead-up to the U.S. bombing of Iran’s nuclear facilities but have since receded. But there’s no telling where this script is going, and stagflation is a serious worry even if higher oil prices aren’t part of it.

That’s because the U.S. now has much higher tariffs in place. While prices have yet to increase meaningfully since President Donald Trump announced the increased tariffs, they will soon enough.

The massive front-loading of imports earlier in the year before the imposition of the tariffs has temporarily attenuated the fallout on prices. Prices will not significantly rise until the non-tariffed inventories are sold off. But that’s imminent.

Small businesses are especially primed to raise prices. Close to one-third of respondents to a prominent small business survey say they plan to raise prices. Other than during the pandemic, rarely has this been so high.

Larger businesses will likely wait longer to raise prices, as they have wider profit margins and more financial flexibility. Besides, they want to avoid losing their market share or becoming a political target, particularly if the tariffs prove to be temporary. That seems increasingly unlikely, and once that becomes clearer, they, too, will raise prices.

The crackdown on foreign immigration adds to stagflation concerns.

The extent of the immigration restrictions is still uncertain, but it is clear that asylum-seekers and the undocumented have stopped crossing the southern U.S. border. Businesses that rely on immigrant workers will find it more difficult to operate, let alone expand, and they will need to raise prices given their higher labor costs.

Take construction. Close to one-third of workers in the construction trades are immigrants, and approximately half of those are undocumented. Without these workers, fewer homes will be built, and renting or owning a home will be even more out of reach.

Similar stories will be evident in agriculture, manufacturing, transportation, leisure and hospitality, and retail.

Given the tariffs and immigration policy, inflation expectations are on the rise again. And it is an open question whether this Federal Reserve will make mistakes similar to those the Fed made 50 years ago, keeping interest rates too low for too long to appease political pressures.

It is hard to fathom enduring the virulent stagflation we have experienced in those times past.

But some version of stagflation isn’t so hard to fathom, and even that would be tough to bear.