What is Stagflation?

Stagflation is like trying to put out a fire only to find that the basement is flooding…

Economic recession is like a fire that burns the economy, causing it to shrink. Floods are like inflation, drowning consumers’ ability to buy goods with their money. Usually, you’d want to put a fire out by using water. But if your home is also starting to flood, adding more water will make things worse. This leaves you with no clear way to solve either problem.

Inflation is an economic phenomenon in which goods become more expensive over time. Put another way, a currency is worth less over time.

You can see the effects of inflation in the prices of many common goods over time. For example, in 2009, a pound of bacon cost between $3.57 and $3.73. In 2019, the same pound of bacon cost between $5.50 and $5.88. Assuming outside factors, such as the supply of bacon and market demand for it, did not play a significant role in affecting costs, you could use the difference in price to calculate the inflation rate.

When economists calculate the inflation rate, they use more than one good. By comparing the changes in price for a basket of goods and services, they reduce the risk that shifts in supply or demand for a single product or other outside factors will skew the calculation.

Typically, wages keep pace with inflation in the US. In 2018 dollars, average hourly wages ranged between $20.27 and $22.65 between 1964 and 2018. This means that people tend to have similar buying power, even as prices rise.

A reasonable inflation rate is generally seen as a good thing for the economy. Central banks typically target inflation rates of roughly 2%. Small levels of inflation benefit an economy by providing a reason for consumers to make purchases rather than putting them off and waiting for goods to fall in price. It also helps borrowers: Because their debt does not increase with inflation, the value of their debt continually falls. A positive inflation rate also gives central banks room to cut interest rates during a recession, since the two rates tend to be correlated. Governments also try to keep the inflation rate stable so that consumers and businesses can plan for the future.

High levels of inflation are harmful to an economy, causing savings to lose value unless interest rates outpace the inflation rate. High inflation can also cause boom and bust cycles and lead to high levels of unemployment, since wages become more expensive. It can also give rise to uncertainty and lower investment.

Economic stagnation is a period of little or no economic growth. Modern economies rely on constant growth to provide jobs and goods for a continually growing population. If an economy stagnates, unemployment can rise, and wages can drop.

Stagnation can result from a variety of factors, including unexpected economic shocks, such as a spike in the price of oil. Stagnation can also be part of a normal economic cycle or come from a structural condition within an economy, like demographic change. As economies mature, stagnation can occur when easy opportunities for growth have already been exploited. Stagnation can also affect developing economies if there is a lack of economic resources or political will to spur growth.

Stagflation is a combination of stagnation (when economic output grows more slowly or shrinks instead of growing at a reasonable pace) and inflation (rising prices). Stagnation causes wages to drop and unemployment rates to rise, while inflation causes prices to increase and money to lose value. It’s the worst of both worlds, which makes things difficult for everyday people.

In the 1970s, the US saw a significant period of stagflation, with inflation reaching a high of 13.3% and unemployment peaking at 11%.

In the 1960s, the US government spent significant sums on the Vietnam War. Foreign competitors also started catching up with America’s manufacturing industry, increasing competition. Factory jobs declined, and many workers moved into lower-paying service jobs. Unemployment began to rise as the labor market got more saturated, with more returning service members, women, and immigrants entering the workforce.

President Richard Nixon responded to these economic challenges with regulations freezing wages and prices. He also ended the gold standard, making it easier for the Federal Reserve, the nation’s central bank, to control the value of the dollar. Ultimately, the benefits of his actions were short-lived and did not resolve the true causes of the problem.

The event that set off the worst period of stagflation was the 1973 oil crisis, which began when the Organization of the Petroleum Exporting Countries (OPEC) launched an embargo. The measure targeted countries that supported Israel during the Yom Kippur war, including Japan, Canada, the US, the UK, and the Netherlands.

The price of oil rose nearly 400% when the embargo began, forcing consumers into gas lines if they wanted to fill their tanks. Prior to the embargo, many Americans preferred larger cars with more powerful engines. High gas prices led consumers to prefer more fuel-efficient vehicles, many of which were produced by Japanese and German manufacturers, further hurting the American manufacturing economy.

Some Western economies responded to stagflation and recession by increasing government spending. The UK, France, Italy, and Canada worked to stimulate the economy. The additional expenditures failed to reduce unemployment and increased inflation further. Others, including Germany and Switzerland, worked to reduce inflation, which caused unemployment to spike.

By 1980, the United States managed to curb stagflation by altering its monetary policy to reduce inflation to reasonable levels. Its efforts succeeded but played a role in causing a recession in the early 1980s.

The causes of stagflation are complicated because there must be a combination of factors that increase both inflation and unemployment.

In the case of the US, one major cause was the government’s high levels of spending, especially on the Vietnam War, combined with policies and events that increased unemployment or reduced the supply of goods.

The US saw massive growth in the decades after the end of World War II. It was one of the only major economies of the world that remained mostly undamaged by the war. This gave it a massive competitive advantage over other countries when it came to producing and exporting goods. The GI Bill created a well-educated workforce, which grew the middle class, and spending on infrastructure, including the Interstate Highway System, led to greater connection and smooth transportation of goods.

This led to the gross domestic product (total value of domestic economic output) of the US growing from $280B in 1950 to more than $1T by 1970.

As other countries began to catch up and compete more effectively with American manufacturers and government spending rose too high, the economy reacted. Growth slowed, wages dropped, and the prices of goods soared. The oil embargo led to considerable increases in oil costs, which impacted travel, manufacturing, and people’s daily commutes and set off the worst period of stagflation.

Preventing stagflation involves keeping inflation under control while maintaining steady growth in an economy.

Today, central banks actively work to maintain stable inflation rates by using a variety of economic levers. Typically, the target inflation rate is around 2%.

A central bank’s primary tool for controlling inflation is setting short-term interest rates. In the US, this is known as the federal funds rate. When inflation is too high, the central bank increases the federal funds rate, which encourages consumers to spend less and lenders to tighten credit requirements. As people save more and borrow less, prices rise more slowly to account for reduced demand.

Conversely, lowering short-term interest rates encourages banks to lend more money and consumers to spend more on goods and services. This spurs demand, allowing prices to rise. If inflation rates are too low, central banks tend to decrease rates to spur higher inflation.

The other half of preventing stagflation is ensuring constant economic growth. This can be difficult, as economies tend to be cyclical, going through periods of growth and periods of recession (known as the business cycle). In the 1970s, the US government accepted that it would need a recession to get inflation under control.

To prevent stagflation, the government has to react to worsening economic conditions, working to spur spending and growth. The most common strategy for doing this is reducing interest rates, which can increase inflation. That means central banks need to strike a fine balance, managing both growth and inflation to avoid stagflation.

Stagflation is painful to fix because the typical levers for spurring growth increase inflation, and the levers for reducing inflation can cause the economy to shrink. This leaves central banks with what seems to be an impossible task, since solving one problem makes the other worse.

Economist Milton Friedman argued that the only way to fight stagflation was by fighting inflation. Reducing inflation would allow an economy to deal with the true causes of unemployment, while increasing spending to combat unemployment would lead only to short-term benefits and long-term increases in inflation.

When investors face stagflation, it can be challenging to find opportunities for growth, and inflation continually eats away at the value of their investments. As inflation increases, the value of returns on bonds diminishes and can even result in losses if the inflation rate climbs high enough. A stagnating economy also means that it can be difficult to find growth in stocks.

One option is investing in real estate. Rents have risen faster than inflation (and wages) over the decades. But if economic stagnation turns into recession, in some housing markets you may be unable to find renters, leaving you with an asset that produces no income.

Another option is to focus on large, well-established companies with significant foreign dealings, especially if they operate in countries that are not experiencing stagflation. A weakened currency makes exports cheaper for buyers in other countries, which can help exporters increase sales.

Stagflation is a bad thing. It is a combination of three undesirable economic situations: high levels of inflation, high unemployment, and very slow growth. Central banks try to guide an economy to reasonable rates of inflation and growth, maintaining employment and good economic conditions for society. Stagflation tends to increase unemployment and prices, making it difficult for people to buy the goods they need and find new economic opportunities.

Stagflation is also bad because it is so difficult to solve. A typical solution for poor economic performance is to boost government spending. However, bumping up spending can increase inflation. Governments generally control inflation by raising interest rates, but that can reduce spending and weaken the economy. Because of these competing factors, it can be incredibly challenging to get an economy out of stagflation.