How Stagflation Affects FX
Aug 18, 2022
Do you know what stagflation means? It is a period where economic growth is slowed to a stagnant speed. Not only that, but there are also high levels of inflation. As you might have guessed, these two alone can be dangerous to an economy but paired together, the damage can be severe and long-term. And, of course, if you’re caught in the middle of it all, you might be stressed out trying to figure out what you can do to limit fx risk. This is the problem that many other people face as well, especially those caught in stagflation or other types of economic downfalls.
With inflation rates reaching 9%, the UK is experiencing the highest inflation level in forty years. Pair that with weaker-than-expected economic growth, and the UK is on its way to stagflation, an issue that, to no one’s surprise, is occurring given what’s happening.
How will stagflation affect the forex exchange market? Well, not in a good way. To help you thoroughly understand how stagflation affects FX, let us delve deeper into stagflation itself:
What Is Stagflation?
Stagflation is a term coined by the British for the combination of stagnation and inflation. At this point, you might be accustomed to inflation, as it is a cycle that all economies go through. The way it works is simple, and it usually comes in the form of a rise in the prices of goods and services. In the UK and across the world, the inflationary threshold is usually 2.5%.
It is true that inflation makes economic growth more difficult, but it also means that companies can keep business costs in check. That leads to fewer layoffs, and employees are more likely to be retained in today's job market. That is the way inflation usually works. However, stagflation is a little bit different.
Stagflation happens when there is a period where the inflation in an economy becomes higher than the growth rate. This period of time is what we refer to as stagflation. But to understand why stagflation happens, it will help to look at the factors that lead to it.
Why Does Stagflation Occur?
Inflation and economic growth are affected by a number of factors, including the following:
An Inefficient Monetary PolicyThe monetary policy of a government can impact inflation and economic growth. The way an economy works is that the central bank of that country creates and manages money. When it does, it usually prints more money for use by consumers.
When the money supply grows too rapidly, inflation occurs. That is why the Bank of England is so clear about its stance on inflation. It wants to ensure that inflation remains at a low level. However, when the central bank of a country prints or lends too much money, it has a serious effect on the economy.
That is why stagflation can happen. For example, the US experienced stagflation in the 1970s because the Federal Reserve created too much money. As a result, consumers and businesses were burdened with too much money, meaning that demand for goods and services was too high for supply. Although the economy was growing at a modest rate, inflation remained high.
Regulations can force businesses to increase prices to cover costs. This is a simple reality of running a business. For example, as a business owner, you can choose to pass on higher costs to your customers. That is exactly what businesses do in order to make a profit.
The problem comes in when regulations in a country are too rigid. That can increase the costs of doing business. In a strange way, that can lead to a lack of GDP growth.
As we mentioned earlier, inflation rates have been surging in the UK and around the world. That is because of a massive increase in regulations being introduced, and it is happening across all industries, including the FX market.
The UK government has been implementing ever-increasing regulations on the FX market. That is why the banks and companies in the UK have had a hard time as of late. Stagflation is a reality of Brexit and the issues it brings.
Changes in the Supply Of Commodities
The rise of stagflation can also be blamed on the price of goods and services that the economy uses the most. For example, when the price of oil rises, it has an impact on the overall value of the goods and services in the UK economy.
If a country relies on oil as its main source of energy, the increase in oil prices will also cause gasoline prices to rise. Notably, gasoline prices affect the price of goods and services across the board, which can eventually lead to stagflation.
A good example of how the price of commodities can impact an economy, especially a developing one, is Nigeria. What happened was that, as the price of oil hit historic highs, the Nigerian government saw its revenues rise as well.
The problem was that the government had not factored that into its budget, and the high purchasing power of its currency caused inflation to soar to a high level. This led to stagflation in Nigeria.
In the case of the UK, the rise in oil prices has caused the inflationary cycle of the pound to reach almost 9%. That is the highest level of inflation that the UK has experienced in forty years.
These are just a few of the causes of stagflation, and there are many more that are thought to lead to and cause stagflation.
What Are the Symptoms of Stagflation?
As mentioned earlier, the symptoms of stagflation can be pretty devastating to the economy. In fact, it can really hurt a country's ability to maintain steady growth.
You see, high inflation rates can lead to higher interest rates. This is because banks need to give their customers a higher interest to keep their money safe.As a result, the yields that you can get from banks and other monetary units decline, which means that you are getting a smaller percentage of profit for your money. In addition, this can also lead to a decline in the value of the currency for obvious reasons.
With stagflation, the country's economy will likely experience a decline in the growth rate. In an attempt to combat inflation, governments will likely raise their interest rates as well in a bid to keep the value of the currency more competitive in the world markets.
This is why stagflation is such a dangerous combination. Not only is the economy slowing down, but people are also afraid to spend their money due to the high prices.
Why Exactly Is Stagflation Dangerous to an Economy?
While we have mentioned stagflation leads to the price increase of goods and services and a slow down of the economic growth rate, the biggest danger lies in the people living in the country.
How so? People usually start to panic when this happens, and this can also lower their confidence in the economy. As a result, they will be less likely to spend big, which will only make stagflation worse. Things do not get any easier either as more people are left unemployed, giving them little to no reason or motivation to spend.
What Examples of Stagflation Have Occured in the Past?
Just like the theory behind stagflation, the causes that have led to stagflation also have their roots in the past. The term stagflation was first used in the 1970s when the first stagflation also happened. During this time, apart from the overprinting of money, the price of goods was going up due to the oil crisis and the Vietnam War. As a result, a lot of people lost their jobs, and this caused slow economic growth.
Another example of stagflation was the Latin American debt crisis of 1982. During this period of high stagflation, the Latin American nation's economies were also faltering. There was a surge in the unemployment rate, while other economic indices were also declining, leading to stagflation.
Stagflation also occurred in the UK, where inflation peaked at 7% in the UK, and the growth rate was nil. In fact, there was a negative growth of 1.2%. However, the UK would recover in 1987 and make a comeback by posting a rate of 4.5% by the end of the decade.
Is Stagflation Worse than Recession?
Simply put, yes, stagflation is worse than a recession. Why? Because it lasts a lot longer. Recessions are usually caused by a single negative event or a few events that are easy to remedy, but stagflation is caused by various factors that occur at the same time, leading to a situation that's incredibly hard to recover from.
Because stagflation is the cause of more problems than recessions, it makes it much harder to solve. Varying factors can be linked to one another, causing a chain reaction of problems that can be tough to overcome and lead to serious consequences.
How Does Stagflation Affect the FX Market?
Stagflation can be a lot worse for the FX market as well. Aside from the impact on asset prices, stagflation can also cause problems for the currency markets.
When stagflation occurs, many people start to lose their jobs, resulting in a decline in overall consumer spending. This helps to create a vicious cycle, where less consumer spending gives the economy more room to decline and, in turn, hurts a country's currency heavily.
As a result, there is a decline in the demand for a country's currency. This is because there needs to be more demand, coupled with the decline in consumer spending. This causes investors to lose confidence in a specific currency, meaning that fewer and fewer people will trade with it.
How Do I Protect Myself from Stagflation in the FX Market?
With all things considered, the best way to protect yourself from stagflation is to diversify your portfolio. We know that stagflation is caused by multiple factors, so why not have a strategy that can adapt to those factors?
There are a few ways that you can do this. For starters, you can invest in different countries. Stagflation is not a problem that a single nation can solve. It is a problem that every country in the world will have to face. Of course, you can only invest in some countries out there, but between a few countries, you can still get a good return. One example is investing in Australia and Canada, which have a lot of similarities to the UK but don't have the same problems.
The second method you can use to protect yourself from stagflation is by investing in assets that are "safe havens". Basically, you should invest in assets that are less likely to be affected by the problems that you might see in value during stagflation. Some examples of this are gold and bonds. Investors are willing to buy gold because they know that during a time of economic uncertainty, they will be able to sell gold and get a good return out of it.
In addition, bonds are considered to be a "safe haven" for investors because of the fact that a bond will give you a steady income, no matter if the economy is doing great or not.
While it might not be a daily problem for you, it is definitely something that you should know about and keep an eye out for. That way, you can be better prepared for stagflation should it occur and be prepared way before stagflation even affects an economy. This is the only way you can protect your hard-earned money, ensuring financial safety regardless of what's happening in the world.
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