What is Stagflation?

June 23, 2022

Stagflation, a combination of stagnation and inflation, refers to the economic situation where inflation is high, the economic growth rate slows, and unemployment remains high.

Stagflation is a term used to describe a stagnant economy, burdened by slow growth and high inflation. This combination is counter-intuitive as higher inflation often goes hand-in-hand with economic growth, but it was proved possible during the 1970s and early 1980s. In these time periods, workers in the US and Europe faced high unemployment and a loss of purchasing power.

The Phillips Curve

Until the 1970s, economists viewed stagflation as near-impossible due to the theory called the Phillips Curve, named for its creator, economist A.W.H. “Bill” Phillips. The Phillips Curve held that inflation and unemployment moved in opposite directions.

Intuitively, this makes sense. When the economy is weak and people are out of work, businesses are unable to raise prices, keeping inflation low. When the economy is growing enough for businesses to pass along large price hikes to their customers, unemployment should stay relatively low. This obviously is not always the case.

Inflation vs Stagflation: What’s the Difference?

What is Inflation?

Inflation refers to the general increase in the price of goods and services in the economy. When the general price level of goods increases, each unit of currency can purchase fewer goods or services; therefore, inflation corresponds to a reduction in purchasing power.

Central banks such as the Federal Reserve prefer modest inflation to none at all, as insurance against destabilizing deflation. Policymakers generally aim for inflation of 2% to keep economic growth steady.

Stagflation vs Inflation

The only difference between inflation and stagflation is economic growth. Generally, inflation is coupled with economic growth, and can even be a byproduct of a rapidly expanding economy. On the other hand, recessions usually slow inflation. Stagflation refers to the rare and counterintuitive phenomenon of a recession coinciding with prolonged high inflation.

Stagflation of the 1970s

Saudi Arabia and other oil-producing countries imposed an oil embargo on the United States and other countries that supported Israel in the 1973 Yom Kippur War leading to an oil crisis. Oil prices soared and remained high, pushing the cost of living high enough to be unaffordable for many. Stagflation then began.

Each year from 1974 to 1982, the inflation rate and unemployment in the US both topped 5%. The combination of these two measures came to be known as the “misery index.” The misery index peaked at 20.6 in 1980.

In the early 1980s, Fed Chair Paul Volcker increased interest rates so high to fight inflation – 30-year mortgage rates reached a whopping 19% in 1981. This dramatic increase caused back-to-back recessions in 1980 and 1981-82. Despite these recessions, Volker achieved his goal of ridding the economy of hyperinflation.

What Causes Stagflation?

Economists offer two explanations for stagflation. First, stagflation can occur when the economy faces a supply shock, such as a rapid increase in the price of oil or another natural resource. This tends to raise prices at the same time as it causes slow economic growth by making production more costly and less profitable.

Second, the Fed can cause stagflation if it implements monetary policies that burden industries while growing the money supply too quickly.

Stagflation in 2022

Currently, there is rapid inflation — consumer prices jumped 8.6% in May from a year earlier, the highest increase since December 1981. Consumer price levels are surging largely because of how quickly the economy rebounded from the Covid-19 pandemic downturn. Factories, ports, and freight yards have been overwhelmed trying to keep up with an unexpected jump in customer orders. This has led to supply chain issues including delays, shortages, and higher prices.

But the economic stagnation half of stagflation has yet to arrive. At 3.6%, the unemployment rate is just a hair above 50-year lows. Still, the risk of stagflation is still present. Fed Chair Jerome Powell acknowledged that the central bank may not be able to achieve a soft landing and dodge a recession. He cited “factors that we don’t control” including the Ukraine crisis, a slowdown in China, and the lingering effects of the pandemic.

Inflation has been eroding Americans’ purchasing power recently. Prices of goods have risen faster than hourly pay for 13 straight months. The nation’s savings rate, which soared in 2020 and 2021 as Americans banked government stimulus checks, has fallen below pre-pandemic levels.

Europe is more vulnerable to stagflation than the US today. Energy prices have skyrocketed since Russia’s invasion of Ukraine while unemployment in the 27 EU countries has reached 6.2%.

This material is provided for informational purposes only and should not be relied on as investment advice. 

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