What is stagflation? Everything investors need to know

Stagflation is a rare economic malfunction that comes with a deadly combination of high inflation, low growth, and high unemployment.

Stagflation is a rare and problematic combination of high inflation, low economic growth, and a high unemployment rate. Economists once believed that stagflation was impossible. However, in the 1970s, this belief was disproved. And what followed was nearly a decade of volatile and chaotic economic activity.

What is stagflation?

Stagflation is a term used to describe a poorly functioning economy. The price of goods and services continues to rise, causing inflation. Meanwhile, economic growth stalls. With business profits under pressure even after rising prices, unemployment begins to rise.

Needless to say, it’s not good. And to make matters worse, fixing such economic conditions is exceptionally difficult. A central bank, such as the Federal Reserve or the Bank of England, has only limited tools to control monetary policy. And these often cannot be used in combination.

Introduce a contractionary monetary policy to reduce inflation. But it will also cause more unemployment and likely lead to a recession as economic activity slows further. On the other hand, stimulating the economy will help reduce unemployment and reintroduce growth. Unfortunately, this course of action will also drive inflation higher. It’s a catch-22.

What causes stagflation?

There is no common consensus on what leads to such a rare economic event. However, looking at historical examples, some factors can theoretically lead to another round of stagflation.

• supply shocks – When an economy experiences a sudden increase in demand or a decrease in the supply of a good or service, a supply shock is created. This can lead to sudden increases in the price of these goods, causing inflation. This was a major contributing factor to stagflation in the 1970s. In 1973, the Organization of the Petroleum Exporting Countries (OPEC) triggered an oil embargo against Western countries, including the United States and the United Kingdom. This caused the world price of oil to skyrocket, increasing the cost of energy and production, leading to wage cuts, higher unemployment, and inflationary price increases.
• poor economic policy – Prolonged periods of artificially low unemployment can lead to a spiral of wages and prices. This is where employees demand higher wages. Companies that give raises to workers pass this cost on to customers by increasing the price of their goods and services. This creates inflation which results in higher demand for more wage increases in a vicious cycle. The end result is low unemployment with rising inflation.
• Loss of the gold standard – In the past, the value of the US dollar and the British pound sterling were linked to the price of gold. However, this monetary policy was eventually abolished to give governments and central banks more flexibility in dealing with economic shocks. However, this also opened the door for excessive increases in the money supply. If not handled correctly, it can create runaway inflation. And in extreme cases, even hyperinflation.

Is stagflation worse than a recession?

Yes, stagflation is significantly more problematic than a normal recession. The latter is a fairly common event as economies operate in cycles. And there are always periods of expansion followed by contraction.

However, recessions are generally not accompanied by high inflation. As such, a central bank can enact a new expansionary monetary policy to stimulate economic growth. This usually involves increasing the money supply enough to improve access to capital for businesses without creating excessive inflation.

During stagflation, fixing a recession is much more challenging. Central banks will normally choose to address high inflation before tackling a recession. But since an economy is usually already in recession during stagflation, tightening monetary policy will increase the severity and pressure on consumers and businesses.

Only once inflation is back under control will central banks start to stimulate the economy again. But to ensure that inflation stays within target levels, this process can take years, during which time poverty, hunger and unemployment reach high levels.

How to fix stagflation?

Due to the rarity of this economic event, there is no known definitive solution to fix it. However, economists have developed general theories of what must be accomplished to restore an economy and a currency.

One plausible solution is to increase economic output and increase output to the point where growth can be achieved without creating additional inflation. This will help solve any supply crisis. And it also allows a central bank to introduce a contractionary monetary policy to control inflation without hurting economic growth.

Of course, achieving this is much easier said than done. And it can often require radical and disruptive decision-making by governments that is likely to lead to civil unrest.

Which countries have experienced stagflation?

The most famous example of stagflation is that of the United States during the 1970s. The country enjoyed significant economic expansion in the 1950s and 1960s after the end of World War II. However, the booming economy resulted in the government introducing bad economic policies as well as the abolition of the gold standard.

By themselves, these decisions were not a major problem. But when combined with an oil supply shock, it became a catastrophe. In 1973, OPEC announced its oil embargo against nations that supported Israel during the Yom Kippur War.

With the US economy heavily dependent on oil for transportation and manufacturing, economic growth has stalled while commodity prices have skyrocketed. Companies were forced to start laying off employees, leading to a rise in unemployment. The end result was high inflation, stagnant economic growth, and high unemployment.

Stagflation also spread to the UK economy during the same period due to similar circumstances. But, in addition, the United Kingdom suffered further supply crises from the loss of imports from its colonies, as many claimed their independence. This, combined with miners strikessent inflation up to 40%.

The bottom line

The three characteristics of stagflation are a very lethal combination for everyone: the people, the government, and the entire economy. With no real solution to deal with it, central banks are very cautious to prevent stagflation conditions from happening in the first place.

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This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment depends on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor should consider his or her individual financial circumstances and contact an independent financial adviser if necessary.