What Is Stagflation, What Causes It, and Why Is It Bad?

Because bouts of stagflation are so rare, very unusual events must occur to create a backdrop whereby the economy is “dead in the water,” and there’s high inflation, notes Brad McMillan, chief investment officer at Commonwealth Financial Network. While it’s unlikely that the U.S. economy is headed for another bout of stagflation, it’s important to contextualize what’s happening with the prominent episode of stagflation in the 1970s. This decision removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a fiat basis, ending most practical constraints on monetary expansion and currency devaluation.

1. The last major bout of stagflation took place in the 1970s, when an oil shortage sent gas and other related prices soaring as it simultaneously dragged down economic output.
2. Many economists now believe that the growth of the money supply by the Federal Reserve was the main factor in the stagflation crisis of the 1970s.
3. The lack of purchasing power ripples through the economy, denting business revenue and draining savings, Harvey said.
4. The law of supply and demand suggests demand will moderate in that case only in response to higher prices.
5. In recessions, as demand slumps, inflation tends to be low and unemployment high.

Stagflation can directly impact investors by decreasing the growth in companies’ earnings per share, which impacts stock prices. Stagflation is a period of stagnant economic growth accompanied by persistently high inflation and a sharp rise in unemployment. While stagflation is quite rare—the U.S. has only experienced one sustained period of stagflation in recent history, in the 1970s—it’s become a more frequent topic of speculation. The consensus among economists is that productivity has to be increased to the point where it will lead to higher growth without additional inflation.

“They don’t have that many tools to fix the supply-chain problems. But that means the demand adjustments need to be even harder,” Spatt said. “I think we’re going to see higher interest rates to reduce demand — reduce demand by companies, reduce demand by consumers.” “Global factors pushing up on prices, particularly energy prices … could potentially cause inflation to remain high or rise further, even if  the domestic economy is starting to weaken,” Hunter said.

Business & economics

The wage-price spiral is what can happen when policymakers fail to bring inflation under control. Increasing aggregate supply via policies designed to support business to reduce costs and increase efficiency like deregulation and suspending tariffs could be used to address cost-push inflation. But these strategies are often ruled out as they are national policies to address global supply shortages. Proposed by economist Eduardo Loyo, the demand-pull stagflation theory suggests that stagflation can occur exclusively from monetary shocks without the need for a supply-related shock.

It led economist Arthur Okun to come up with a misery index summing the inflation and unemployment rates, and the name encapsulates how that period of economic history is remembered. Economists have long struggled to understand what causes stagflation and how best to intervene when it happens. Stagflation is a challenging problem to face, making it difficult for central banks and policymakers to respond effectively. Stagflation generally results in lower profit margins due to higher input prices and lower sales. That has an impact on the stock market, as the S&P 500 in the last 60 years has returned an average of 2.5% per quarter but historically returns -2.1% during times of stagflation, according to a Goldman Sachs report.

In particular, the economic theory of the Phillips Curve, which developed in the context of Keynesian economics, portrayed macroeconomic policy as a trade-off between unemployment and inflation. Stagflation is an economic cycle characterized by slow growth and a high unemployment rate accompanied by inflation. Economic policymakers find this combination particularly difficult to handle, as attempting to correct one of the factors can exacerbate another. Usually, to get companies hiring again and the economy back up and running, interest rates are cut.

Match lots of people out of work and sluggish economic growth with high inflation, and you have stagflation. The explanation for the shift of the Phillips curve was initially provided by the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued that when workers and firms begin to expect more inflation, the Phillips curve shifts up (meaning that more inflation occurs at any given level of unemployment). While this idea was a severe criticism of early Keynesian theories, it was gradually accepted by most Keynesians, and has been incorporated into New Keynesian economic models.

While this combination may seem counterintuitive, it proved real during the 1970s and early 1980s when workers in the U.S. and Europe were subjected to high unemployment as well as the loss of purchasing power. There are other ways that investors can hedge the risk of inflation, including investing in funds that are designed specifically to navigate periods of high inflation. As is the case in any market or economic environment, long-term investors are wise to maintain diversification https://www.wallstreetacademy.net/ and to continue dollar-cost averaging and periodic portfolio rebalancing. The pivot of the U.S. economy from manufacturing to less well-compensated service jobs caused real wages to stop growing and led to decreased consumer confidence and reduced spending – further exacerbating the crisis. Historically, Nixon’s ending of the convertibility of U.S. dollars to gold, which prompted the end of the Bretton Woods System, is theorized as one driver of 1970s stagflation.

Is stagflation worse than a recession?

At this point, a lot depends on the effectiveness of interest rate rises curtailing demand and whether major supply shocks can be ironed out quickly. If inflation doesn’t ease soon, then the U.S. and global economies could face more than just a regular recession. Most economists, following a series of interest rate increases, persistently high inflation, stock market volatility, and muted economic growth, have now accepted that a downturn is coming.

In the past 50 years, every declared recession in the U.S. has seen a continuous, year-over-year rise in consumer price levels. Should we soon find ourselves in this situation, the consequences could be catastrophic. As Roubini points out, private and public debts are much higher than in the past, accounting for about 350% of global gross domestic product (GDP) because interest rates were low for ages. Now that this is changing, a storm is brewing, with higher borrowing costs threatening to push leveraged households, companies, financial institutions, and even governments into bankruptcy and default. High prices squeeze household budgets and reduce consumer spending, while weak economic activity means businesses grow slowly, if at all, and corporate profits slump.

What is stagflation? A double whammy of headwinds

The demand for gas did not change but the lack of supply raised the price of gasoline to $5 a gallon. Erika Rasure is globally-recognized as a leading consumer economics subject matter expert, researcher, and educator. She is a financial therapist and transformational coach, with a special interest in helping women learn how to invest. In October 1973, the Organization of the Petroleum Exporting Countries (OPEC) declared an oil shipping embargo to the United States and Israel’s European allies in response to Western support of Israel during the Yom Kippur War. In addition to the World Bank, other major institutions—like Goldman Sachs and BlackRock—also warned about stagflation risks.

Demand-pull inflation can result from loose fiscal and monetary policies or from inadequate investment. In all those cases, monetary and fiscal tightening is the likely outcome, since investments in increasing the economy’s productive capacity often take a long time to produce results. Responding to inflation is difficult for both central banks and policymakers since targeting one aspect of the problem can have a negative impact on another aspect of it. For example, increasing interest rates elevates the cost of borrowing and reduces demand which reduces inflation but also causes slower GDP growth. However, most economists now agree that the one thing missing, higher unemployment, could soon become a reality as loftier costs to service debt tempt companies to lay off employees.

The advent of stagflation across the developed world later in the 20th century showed that this was not the case. Stagflation is a great example of how real-world experience can run roughshod over widely accepted economic theories and policy prescriptions. The term was revived in the U.S. during the 1970s oil crisis, which caused a recession that included five consecutive quarters of negative GDP growth. Recessions are considered a normal part of the economic cycle, happen quite often, and historically last just under a year. Stagflation, meanwhile, is uncommon and, when it does rear its ugly head, tends to stick around. These types of economic crises are difficult to defeat because the traditional play of lowering borrowing rates to stimulate growth is taken off the table.

Inflation is unusually high, and the economy is, well, not exactly firing on all cylinders. In the 1970s, this toxic stew of high unemployment and high inflation persisted for over a decade as the U.S., U.K. McMillan says that paying attention to both the underlying data and the headlines is important. “If you’re an investor, you need to play off expectations as much as reality,” he says.

McMillan argues that based on the 1970s definition, the U.S. could have experienced stagflation—there was a supply shock caused by pandemic-related supply chain issues and a significant increase in the money supply due to the Fed’s policies. A long-lasting surge in prices has been quite rare in modern history and until this year, the inflation rate hadn’t been above 5% for 6 months or more since the 1980s. Experts say that such periods of sustained, high inflation are most likely caused by either a global supply shock or poorly-guided economic policies.

Postwar Keynesian and monetarist views

The inflationism of the currency systems of Europe has proceeded to extraordinary lengths. The various belligerent Governments, unable, or too timid or too short-sighted to secure from loans or taxes the resources they required, have printed notes for the balance. But stagflation never arrived, and McMillan isn’t worried about another episode happening any time soon. He says that’s because the economy is fundamentally different today than it was back then. While the U.S. has sidestepped another bout of stagflation since the 1970s, some commentators have drawn parallels between that episode and recent dynamics in the economy.