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

what is stagflation caused by

Stagflation is a double whammy of economic woes that combines lethargic economic growth (and, typically, high unemployment) with escalating inflation. It’s also a conundrum for fiscal and monetary policymakers, as it turns the Phillips curve on its head. Although the U.S. eventually overcame the stagflation scourge of the 1970s—after a decade of economic doldrums—the causes of stagflation and the best solution for overcoming it remain a matter of debate. 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. President Richard Nixon tried to mitigate 1970s stagflation by devaluing the dollar and declaring price and wage freezes.

  1. Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.
  2. This idea, essentially the diversification of the economies of cities, was critiqued for its lack of scholarship by some, but held weight with others.
  3. The inflation of the 1970s has been variously attributed to the cost-push of oil price shocks and the demand-pull of relaxed fiscal and monetary policies.
  4. Stagflation doesn’t respond to the conventional monetary tools based on the Phillips curve (see figure 1).
  5. Gold performed well in the 1970s, as it and other precious metals are seen as a traditional hedge.

“Stocks have historically delivered high enough returns to beat inflation, but they often need economic growth to do that,” Martin says. When businesses are struggling to turn a profit, earnings expectations fall and with them, stock prices. “Stagflation is often caused by adverse supply-side shocks, for example a sudden increase in the price of essential commodities” Brochin says. This was the case in the 1970s when world food shortages met increased energy costs.

What’s the Difference Between Stagflation and Recession?

The consensus among economists is that productivity has to be increased to the point where it will lead to higher growth without additional inflation. This would then allow for the tightening of monetary policy to rein in the inflation component of stagflation. This implies that attempts to stimulate the economy during recessions could simply inflate prices without promoting real economic growth. Another theory is that the confluence of stagnation and inflation is the result of poorly made economic policy. Harsh regulation of markets, goods, and labor in an otherwise inflationary environment are cited as the possible cause of stagflation.

what is stagflation caused by

As we normally understand the economic cycle, economic growth comes with an increase in jobs and, eventually, a rise in the price of goods and services, aka inflation. (The Fed’s target for “healthy” inflation is around 2%.) In contrast, when the economy slows, the job market begins to contract, and inflation also cools. It seems like a simple solution—lowering/raising interest rates to stimulate or slow down the economy, as if all the central bank has to do is flip a switch. During the 1970s, the rate of inflation was already rising when a series of oil supply shocks caused by the Organization of Petroleum Exporting Countries (OPEC) oil embargoes resulted in oil prices tripling or even quadrupling very quickly. “After surging in 2020 on government income support for the COVID shock, the U.S. broad money supply is falling for the first time since the late 1940s,” Wieting says.

Hedging Against Inflation

Finally, even if the pace of economic growth slows, investors should focus on tweaks to their asset allocations rather than wholesale changes. “Don’t panic and do something foolish, still kind of stay the course,” Bond says. In the 1970s, economist Arthur Okun developed an index to measure stagflation that is calculated by adding the unemployment rate to the annual inflation rate.

America’s Federal Reserve, in contrast, took too long to fight inflation, and had to break the new inflationary psychology later, under the leadership of Paul Volcker, through a painful recession. In recessions, as demand slumps, inflation tends to be low and unemployment high. A period when both inflation and unemployment are high is therefore unusual—and undesirable, as both widespread joblessness and rising costs of living are painful. Attempts to squash unemployment and boost the economy, for example through added public spending or very low interest rates, risks generating inflation. 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.

what is stagflation caused by

Those supply shocks followed a period of accommodative monetary policy in which the Federal Reserve grew the money supply to encourage economic growth. Meanwhile, global economic growth slowed sharply in the 1970s—a decade marked by two different recessions in the U.S. and the lead-up to a third one that began in 1980. In the neoclassical viewpoint, the real factors that determine output and unemployment affect the aggregate supply curve only. The supply shock theory posits that stagflation occurs as a result of a sudden decrease in the supply of a service or commodity.

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For those who are employed, stagflation could lead to risks of job losses and lower wages, which would decrease consumer confidence and purchasing power. Stagflation is a term used to describe an economy experiencing significant inflation, high unemployment, and slow to no economic growth. The term is a portmanteau that combines the words stagnation in GDP and inflation.

Economic conditions in early 2022 led many commentators to wonder whether the U.S. was headed for a return to stagflation. However, most analysts believe the country’s reduced reliance on imported oil—and energy, in general—plus the Federal Reserve’s credibility should stave off 1970s-style stagflation. 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. Prices rise rather than stay flat or fall, and the tools normally used to fix the economy are ineffective, meaning that this discomfort may last for a long time. This is not only an extremely uncomfortable environment to live in but also quite tricky for governments to fix.

Demand-pull inflation happens when demand for goods and services rises above the economy’s capacity to meet it. The law of supply and demand suggests demand will moderate in that case only in response to higher prices. 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. During the 1970s, the supply of oil tailed off drastically and prices consequently rocketed, first because of an embargo stemming from a war between Israel and the Arab states and later as a result of the Islamic revolution in Iran. Those events, along with easy monetary policy—which the American central bank, the Federal Reserve, pursued to lift employment—caused inflation to spiral out of control and threw the economy into disarray.

She believed that to avoid the phenomenon of stagflation, a country needed to provide an incentive to develop “import-replacing cities”—that is, cities that balance import with production. This idea, essentially the diversification of the economies of cities, was critiqued for its lack of scholarship by some, but held weight with others. Nixon removed the last indirect vestiges of the gold standard, bringing down the Bretton Woods system that had controlled currency exchange rates.

The wage-price spiral is what can happen when policymakers fail to bring inflation under control. This was partly based on the Phillips Curve, an economic model that was used to argue that there was an inverse relationship between unemployment and inflation. Economists have since identified many potential factors that influence stagflation including a sudden supply shock and harmful government 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. “During a period of stagflation, businesses struggle to grow due to slowing economic activity, and cannot easily reduce costs due to rising input prices,” Brochin says.

In the past 50 years, every declared recession in the U.S. has seen a continuous, year-over-year rise in consumer price levels. 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. 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. During a recession, policymakers can turn to expansionary monetary and fiscal policies to stimulate the economy, but these same policies exacerbate the inflationary side of stagflation.

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