In today’s world, economic cycles are inextricably linked to our daily lives. Often their fluctuations seem incomprehensible, like the vagaries of natural elements. However, behind each round of economic development there are quite certain causes and consequences, which are important to understand in order to make trading decisions.
One of the most alarming economic phenomena is stagflation — a situation when a slowdown in growth coincides with a rapid rise in prices. This creates extremely unfavorable conditions for both the population and businesses. People are forced to spend more money on basic needs, while real incomes don’t increase. Businesses are incurring high losses, but cannot compensate for them with revenue due to lower customer demand.
Such coincidence of stagnation with inflation seems to be an economic paradox. After all, according to classical theories, a slowdown in development should be accompanied by deflation — falling prices. Understanding the origins of this contradiction and finding optimal ways out of the stagflationary deadlock is a task of paramount importance for states and international organizations. The stability of the economic situation, the living standards of citizens and the prospects for long-term growth depend on it. In this article we will consider the concept of stagflation in more detail.
Stagflation: what is it and how does it occur?
Stagflation is a term coined in the 1970s to describe the simultaneous combination of economic stagnation and high inflation. It was introduced by Canadian political economist Ian MacLeod in 1965 as an amalgamation of two words: «stagnation» and «inflation».
In classical economic theory, it was believed that stagnation (slowdown in production growth) and inflation (depreciation of money, rising prices) were mutually exclusive phenomena. Stagnation was supposed to be accompanied by deflation - falling demand and falling prices. On the contrary, an increase in consumer activity and a price rally should accompany the acceleration of the economy.
However, in 1973-1975 and 1979-1982, many developed countries faced the paradoxical situation of simultaneous recession and inflation.
The causes of stagflation are reduced to the combined effect of negative factors on the supply and demand sides. For example, due to rising energy prices and declining labor productivity, industrial production fell. At the same time, high inflation was fueled by growing inflationary expectations of the population and the mechanism of wage indexation.
As a result, purchasing power remained high against the backdrop of recession. People continued to spend money, supporting the inflationary spiral. And companies built ever-increasing costs into prices, provoking further growth in the cost of goods and services.
Stagflation was overcome only in the 1980s (and in Russia only in the early 2000s) thanks to structural reforms aimed at increasing productivity, reducing inflation expectations and labor market flexibility. However, the threat of a recurrence of this phenomenon remains relevant and requires close attention of regulators.
Strategies to counter stagflation
Combating stagflation requires a comprehensive approach. There are several main strategies, each of which has its own pros and cons.
- Tightening of monetary policy. This strategy involves regulating the money supply by increasing the discount rate, reserve requirements for banks and other restrictive measures. This leads to reduced liquidity, higher credit costs and, as a consequence, lower aggregate demand in the economy. Low consumer demand has a restraining effect on price growth. However, tight monetary policy negatively affects business activity, investment processes and can provoke a recession with job losses.
- Supply expansion policy. This approach is aimed at increasing aggregate offer by subsidizing and stimulating industries that determine production costs (energy, agriculture, etc.). Tax incentives are also introduced for companies implementing energy-saving technologies or modernizing production. Increased supply with limited demand allows to reduce inflationary pressure without serious damage to economic growth. But such measures require significant budget expenditures.
- Non-intervention and reliance on the free market. Adherents of this concept believe that market forces themselves are able to restore equilibrium between supply and demand through the price mechanism. High inflation suppresses consumer demand, forcing producers to lower prices. Unemployment will redistribute over time — excess labor in some sectors is compensated by its deficit in others. However, such «natural selection» may take many years and require high social costs.
In practice, the most effective anti-crisis program is a comprehensive anti-crisis program that combines various instruments taking into account the specifics of the situation. A reasonable tightening of monetary policy in combination with fiscal incentives for key industries makes it possible to cool down inflationary expectations without a sharp slowdown of the economy. In parallel, measures are being introduced to increase labor productivity, energy efficiency, and support small businesses. At the same time, it is important to avoid excessive restriction of aggregate demand in order not to provoke a prolonged recession.
Impact of stagflation on the cryptocurrency market
The impact of stagflation on the cryptocurrency market is quite ambiguous and depends on a number of factors. Let’s take a look at the most likely consequences:
- Economic stagnation or recession. Low growth or recession leads to a drop in people’s real incomes. Retail investors are left with less spare cash to invest in risky assets, which include cryptocurrencies. Many may start selling off their crypto assets to replenish working capital. Large players and institutional investors will also begin to reduce their exposure to high-risk instruments, including digital currencies.
- Combating inflation. Usually stagflation is tried to stop by tightening monetary policy. Interest rates are raised and issuance is reduced. Due to rising borrowing costs, investments in highly volatile assets such as cryptocurrencies become less attractive. Demand and exchange rates of digital currencies often decline during such periods. But later for the growth of the economy, the government increases liquidity, which is favorable for the crypto market.
- Inflationary factor. Cryptocurrencies are often seen as a defense against inflation. Due to limited issuance, some coins (e.g. Bitcoin) are relatively resistant to depreciation when prices rise. However, during short periods of stagflation, this effect is offset by investor sell-offs.
- Correlation with the stock market. In recent years, the dynamics of cryptocurrency exchanges largely repeat the trends of stock exchanges. In conditions of stagflation, stock indices also tend to decline, which is inevitably reflected in the rates of digital coins. The experience of previous crises has shown that the cryptocurrency sphere reacts strongly to stock market sell-offs and collapses.
Thus, in the short term, stagflation is highly likely to have a negative impact on the crypto market, causing a drop in coin rates. However, in the long term, inflation expectations and measures of government support for the economy may have a favorable impact.
Conclusion
Periods of stagflation pose a serious challenge for cryptocurrency investors and traders. The key danger for market participants is a collapse of leading coins due to massive sell-offs. Private investors and large players in order to preserve capital will seek to get rid of unsafe positions and transfer funds to more reliable instruments.
In such a situation traders should be extremely cautious, reduce the scale of operations and prioritize risk hedging. The transition to the strategy of slow accumulation of key coins with the aim to increase their value in the long term after the end of stagflation may become promising.
Arbitrage — playing on exchange rate differences between key coins and searching for undervalued altcoins — can be a separate direction of trading during stagnation periods. However, such a strategy requires serious expertise.
