The economic term stagflation is a mashup of the words stagnation and inflation — and it’s worth being aware of because of the threat it poses to economies.
Stagflation creates potentially disastrous conditions where people experiencing a decline in purchasing power also feel discouraged against investing. It can create a chain reaction of wealth-destroying events where unemployment climbs and economic output slows, contributing to a national economic malaise.
What Is Stagflation?
Stagflation is a term used to describe a situation when the economy is growing slowly — stagnation — and prices rise rapidly — inflation.
The term was coined by British Conservative Party politician Iain Norman Macleod in a 1965 speech to Parliament. At the time, the United Kingdom was in the midst of simultaneous high inflation and unemployment. In the speech to Parliament, Macleod said, “We now have the worst of both worlds – not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation and history in modern terms is indeed being made.”
Usually, economists and analysts will use the unemployment rate as a proxy for economic activity when discussing stagflation. So, a period of stagflation is when unemployment rises while inflation — as measured by the consumer price index (CPI) — accelerates above normally acceptable levels of price growth.
However, like many economic concepts, there is no standard definition of stagflation. Policymakers, elected officials, and investors will use the term stagflation in various economic scenarios.
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Stagflation vs Inflation
Inflation is a general increase in the average prices of goods and services. In contrast, stagflation is a combination of stagnant economic growth and rising inflation.
Low levels of inflation are normal for an economy; there’s a reason why movie theater tickets cost more today than they did in the 1950s. Inflation doesn’t become an issue until prices get out of control and spiral upwards. Policymakers within the Federal Reserve like inflation to rise about 2% each year.
You can have inflation without stagflation, but you can’t have stagflation without inflation.
Has Stagflation Ever Happened?
Before the 1970s, economists didn’t think stagflation — a period of rising unemployment and inflation — was possible. Theoretically, inflation should decrease when unemployment increases because workers have less bargaining power to get higher wages. So, the theory goes, stagflation shouldn’t happen.
However, stagflation did occur in the United States from the mid-1970s. During the 1973-1975 recession, the U.S. experienced five quarters where the gross domestic product (GDP) decreased. Inflation peaked at 12.2% in November 1974, and the unemployment rate rose to 9.0% in May 1975.
This stagflation cycle was part of a larger sequence of events called the Nixon Shock.
Responding to increasing inflation in 1971, President Richard Nixon imposed wage and price controls and surcharges on imports. This created a perfect-storm condition where, when the 1973 oil crisis hit, those surcharges on imports made prices at the gas pump — and across many U.S. industries — skyrocket to then-record prices. The rising prices helped lead to a wage-price spiral, where inflation led to workers asking for higher wages, which led to more inflation, and so on.
The Federal Reserve raised interest rates to combat the inflation of the early-70s, but this only created a recession and high unemployment without tamping down inflation. Thus, a prolonged economic stagnation accompanying inflation occurred — a stagflation situation.
While the economy recovered slightly in the late 1970s, inflation remained a problem for the rest of the decade. Federal Reserve chairman Paul Volcker eventually hiked interest rates to 20% by 1981, triggering a recession to get inflation under control.
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Will Stagflation Happen Again?
There are debates about whether stagflation will occur again in the United States.
The economy was in a precarious situation in the first half of 2022. Inflation was running hot due to supply chain issues related to the economic fallout of Covid-19, as well as fiscal and monetary policy stimulus. The Federal Reserve started raising interest rates at a historic pace to combat the rising prices. The Fed began an attempt to curb inflation with the hope of a soft landing, in which an economy slows enough that prices stop rising quickly but not so slowly that it sparks a recession.
Like the 1970s, an energy and commodity crisis occurred due to Russia’s invasion of Ukraine; most of the world subsequently placed economic sanctions on Russia. The sanctions led to high oil, gas, and food prices, adding to already hot inflation.
These factors made the chance of stagflation more of a reality. Economic growth, as measured by GDP, declined in the first half of 2022. Inflation was at its highest rate in over 40 years, coming in at a 8.5% annualized rate in July 2022. Because of this, some economists and analysts believe that the economy entered a period of stagflation.
However, other commentators note that the unemployment rate was 3.5% as of July 2022, the lowest in 50 years. Because of this, these commentators claim that there can’t be stagflation.
While no one can predict the future, it stands to reason that events that have happened in the past can happen again. Stagflation may occur again, but this doesn’t have to be a dire situation as long as you prepare your financial situation.
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How Can Stagflation Impact Investors?
Economic stagnation can have several impacts on investors. Firstly, it can lead to lower returns on investment as companies are less likely to grow and expand in a stagnant economy. This can lead to investors becoming more risk-averse as they seek out investments that are more likely to provide stability and income.
Secondly, stagnation can also lead to higher levels of unemployment, which can, in turn, lead to social unrest and political instability. This can make it more difficult for companies to operate in a given country and lead to investors losing confidence in the economy.
A slowdown of economic activity lasting several months sounds like it can only be a bad thing. But a recession does not necessarily mean the death knell for your finances. For some investors, there are, perhaps surprisingly, compelling strategies to consider when the market is down. Volatility may allow investors to buy low and then make appreciable gains as the market corrects itself.
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The Takeaway
Stagflation occurs when an economy experiences simultaneous high inflation and high unemployment. It’s a situation that often leads to decreased spending by consumers and businesses, which can further stall economic growth and investment returns. Stagflation has occurred before in the U.S. — notably during the Nixon Shock of the early 1970s — and there is no reason to think it won’t happen again at some point.
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