Stagflation occurs when an economy experiences high inflation and slow economic growth at the same time. While there’s no single measurement to determine stagflation, it’s characterized by rising prices, high unemployment, and stagnant or negative GDP.
Though stagflation may sound like a warped version of inflation, it’s actually a complex topic that economists still struggle to understand. The economic event occurs rarely but can be devastating to large and small businesses as well as individuals.
So, what is stagflation and how does it occur? In this article, we’ll discuss what you need to know about the confluence of inflation and stagnation, and how to manage your finances during periods of stagflation.
What is stagflation?
Stagflation is a toxic contradiction that occurs when rising prices (inflation) and economic stagnation, marked by slow or negative growth, happen simultaneously.
Because true stagflation defies economic theory, economists may define it in different ways. But generally, stagflation occurs when a country experiences at least one of the following:
- High inflation and high unemployment at the same time
- Rising inflation and falling GDP
- Slowing or shrinking economic output while inflation stays above the Federal Reserve’s 2% target
- A prolonged period of surging costs and stagnant job growth without higher unemployment
Stagflation presents unique economic risks, especially for lower- and middle-class families. While unemployment rates rise and wages stagnate, higher prices squeeze budgets and reduce consumer and business spending. In turn, household purchasing power plummets, corporate profits slump, and financial markets stumble.
In other words, stagflation batters the economy from all directions at once, resulting in low or negative growth and sky-high prices.
The original stagflation
The term “stagflation” arose from a speech by Iain Macleod to the United Kingdom House of Commons in the 1960s. While speaking on the dueling realities of inflation and stagnation, he called the then-current economy a “stagflation situation.” Then in the 1970s, the U.S. and the global economy experienced stagflation again following a slew of bad policy decisions and geopolitical events. (Namely, the 1973 OPEC oil embargo and the 1979 Iranian revolution leading to declining oil supplies and sky-high energy prices.)
Though inflation was already on the rise, higher energy prices pushed the cost of everything even higher. Originally, the Federal Reserve attempted to kickstart growth by increasing the money supply and slashing interest rates. Unfortunately, because businesses couldn’t meet demand, higher prices triggered mass layoffs and back-to-back recessions.
As a result, the U.S. stumbled through five quarters of negative GDP growth. At the same time, inflation doubled in 1973, hitting 12% by 1974 while unemployment soared to 9% in 1975. Stagflation only ended when the Federal Reserve forced another recession by hiking rates so high demand had to drop. Though unemployment temporarily hit 10%, prices stopped rising and supply and demand found a new balance.
What causes stagflation?
Following the events in the ’70s and ’80s, economists and policymakers were forced to redefine inflation to understand stagflation. Now, we understand that rising prices — inflation — can occur in economic expansions and recessions alike. Moderate inflation (defined as around 2% to 4% by many central banks and credit unions) is healthy in a normal economy.
But true and proper stagflation, when inflation soars and the economy crumbles, is wrought by particular elements that combine in proper proportions. Theoretically, any of these causes could lead to stagflation on their own — but more likely, several occur together.
Supply shocks leading to rising prices
Economists generally agree that supply shocks remain a prominent cause of stagflation. When an essential product or commodity suddenly becomes scarce, the lack of supply “shocks” the economy. Due to its newfound scarcity, the product’s price rises, which means the price of downstream products goes up, too.
Consider wheat. When wheat prices rise, goods like bread, pasta, and even beef may get more expensive, too. This can lead to ripple effects where companies increase the cost of their goods or lay off employees to lower costs.
But when something even more essential to economic function — like oil — becomes scarce, the situation grows complicated. Because oil is needed for everything from energy and utilities to shipping and factory production, higher oil prices impact both national and global economies. In turn, inflation may rise while output shrinks due to layoffs or lowered output (such as what occurred in the 1970s).
Poor economic policies
Economists also believe that poor economic policies can cause high inflation and poor economic performance. For instance, too-harsh or too-lax regulation in goods, labor, financial markets, and monetary distribution could lead to stagflation.
Economists also theorize that printing too much or too little money or offering too-high or too-low interest rates can contribute to stagflation.
That said, many of these theories are contradictory. For instance, you can’t have too-high and too-low rates simultaneously. As such, it’s presumed they have to occur at the right time with the right mix of other factors.
Businesses and consumers can often strategize how to handle rising inflation if they know it will remain consistent. But when higher prices jump around, planning becomes a challenge.
For example, consider the inflation rates of the ’70s and ’80s:
As you can see, inflation didn’t stay put — it rose quickly, slowed down, dropped, and spiked even higher. Such price instability makes it impossible for businesses and consumers to balance their budgets. Soon, they take action to protect themselves in ways that can further stagflation.
For instance, workers may ask for pay raises to counteract inflation. In turn, businesses increase their prices to afford higher wage costs. At the same time, businesses and consumers may rush to buy “big” items before their price climbs, leading to shortages and future hikes. Eventually, businesses cut staff to lower costs, forcing employees out of the market while prices remain up.
One way to counteract these shifts is by investing your money wisely. If you’re a beginner to investing strategies, you may want to enlist the help of a brokerage to ensure you have the best chance at high returns. Take a look at the brokerages below to find your ideal match.
Are we headed toward stagflation in 2022?
In 2022, inflation hit its highest mark in four decades thanks, in part, to a few things. This includes severe supply chain disruptions and shortages, sky-high oil prices following the war in Ukraine, and reheating economies as businesses reopen from Covid-19 lockdowns. As a result, it’s estimated that inflation will cost the average family $5,200 this year.
Throughout the Covid-19 pandemic, global economies kept afloat through fiscal stimulus and central bank activity. In the United States, the Federal Reserve also slashed rates to encourage consumer and business spending. Post-pandemic, these moves improved economic growth. Unfortunately, they, along with critical supply chain shortages and the Russia-Ukraine conflict, have contributed to record inflation and continual price increases.
Despite these impacts, the broader economy remains buoyant. As of April, unemployment sat at 3.6%, despite May’s 8.6% annual inflation rate. And though GDP has shrunk somewhat, some of that is because businesses stockpiled inventory in late 2021 to sell throughout 2022.
Additionally, economies and markets function more efficiently now than they did 40 years ago. For instance, improved technology and the advent of wind and solar power means we rely on oil less. Plus, a much larger share of our GDP is composed of “producing” services instead of material goods. Policymakers are also more attuned to inflation now, meaning they can tackle inflation before it hits runaway proportions.
The dangers of 21st-century stagflation
Still, the danger of stagflation remains. Currently, the Federal Reserve has to balance hiking interest rates to lower inflation without tipping the economy into a recession. The Russia-Ukraine war and renewed Covid-19 lockdowns in China continue to threaten supply chains.
Moreover, the World Bank warned in early June that “the danger of stagflation is considerable today. Several years of above-average inflation and below-average growth are now likely.” And former Fed Chair Ben Bernanke noted in mid-May that high price increases and raised interest rates could lead to stagflation in the second half of 2022.
What is the best investment during stagflation?
Some of the best investments during stagflation include value stocks, as their shares trade below their “true” value. Inflation-adjusted bonds that pay interest pegged to the CPI also produce reliable income.
What happens to real estate during stagflation?
During stagflation, the price of real estate rises thanks to inflation. Simultaneously, some homebuyers lose their jobs or see stagnant wages, meaning fewer families can afford a home.
Generally, homeowners with fixed-rate mortgages purchased before the onset of inflation fare best. In these cases, their homes’ values rise while their mortgage costs remain flat.
What is stagflation vs. recession?
Inflation occurs when prices rise and the economy grows, while recessions usually slow inflation as the economy shrinks. Stagflation is a bit of both, occurring when a recession or stagnant economic growth coincides with high inflation.
What is the difference between stagflation and inflation?
Inflation means that one dollar buys less than it used to and is generally accompanied by a growing economy. Inflation is also a key component of stagflation, which crops up when inflation rises but the economy stagnates or shrinks.
- Stagflation occurs when an economy experiences high inflation and low economic growth at the same time.
- Stagflation was first recognized in the ’60s and ’70s when economic policies, supply shocks, and geopolitical events led to record-high inflation and unemployment.
- While there’s no “cure” for stagflation, economists generally agree the key is increasing productivity until higher growth outpaces inflation.
- In the U.S., the Federal Reserve fights stagflation by hiking interest rates, which discourages consumer and business lending and spending.
- Because stagflation is so difficult to handle, the best approach is thought to be proactively preventing stagflation-inducing factors.
- The U.S. isn’t on a guaranteed path to stagflation in 2022, but it could be if supply shocks and inflation don’t ease off.
View Article Sources
- Money and Inflation — Federal Reserve Bank of St. Louis
- The Employment Situation – June 2022 — U.S. Bureau of Labor Statistics
- Stagflation Risk Rises Amid Sharp Slowdown in Growth — The World Bank
- Inflation Is Costing the Average Family $5,200 This Year — SuperMoney
- Believe It or Not, Real Estate Affordability Hasn’t Changed Much in 40 Years — SuperMoney
- Inflation Breaks a 40 Year Record — SuperMoney
- What is Cyclical Unemployment? — SuperMoney
- 2022 Inflation Study — SuperMoney