What Is Stagflation and How Can You Prepare for It?

Published on: 22.01.2023
What Is Stagflation and How Can You Prepare for It?

In a lecture in 1965, British politician Iain Macleod then used word “stagflation” for the very first time. This was during a time when the UK economy was in trouble. He called the combination of low growth and rising prices a “stagflation predicament.”

What Is Stagflation?

The term “stagflation” is an anagram for “stagnant inflation.” It’s a term used to describe the state of the economy in the context of increasing costs and poor growth (economic stagnation) (inflation). Iain Macleod, a member of the British Conservative Party, first the phrase in a House of Commons speech in 1965 “Right now, instead of having one bad outcome, like inflation or stagnation, we have both of them. We are seeing the making of contemporary history in what amounts to a “stagflation” scenario.” Many economists at the time argued that stagflation was impossible. Indeed, historically speaking, inflation and unemployment have followed inverse correlations. Stagflation, however, is real and may have disastrous effects on the economy, as the 1970s “Great Inflation” era finally showed.

Stagflation vs. Inflation

While there is some overlap between inflation and stagnation, the two concepts are distinct. Inflation is defined as a rise in the general level of prices in an economy over time and not merely an increase in the prices of certain products and services. If the growth in the money supply exceeds the growth in economic output, then inflation occurs.

When inflation occurs with poor economic growth and significant unemployment, this condition is known as stagflation. Generally speaking, these economic phenomena don’t coexist. The unemployment rate and price increases have a negative correlation. So, generally speaking, inflation rates fall when unemployment rates rise and vice versa. However, the stagflation that occurred in the 1970s showed that this connection isn’t always steady or predictable.

History of Stagflation

It was initially thought that stagflation couldn’t happen. Economics theories that were prevalent in the 20th century’s academic and governmental circles could not account for it. The macroeconomic policy was seen as a compromise between inflation and unemployment in the framework of the Phillips Curve hypothesis, which emerged during the Keynesian era of economic thought. Economists worried about deflation after the rise of Keynesian economics and the Great Depression, which held that efforts to reduce inflation boost unemployment, and those to reduce unemployment decrease inflation.

However, the emergence of stagflation in the developed world towards the end of the 20th century proved that this wasn’t the case. The stagflation of the 1970s and 1980s is a classic example of how actual conditions may trample on theoretical or policy recommendations in the field of economics.

Inflation has shown its durability since then, continuing even during times of  negative economic development. All 50 U.S. recessions during the previous half-century have been accompanied by year-over-year increases in consumer prices.

The only time this was even partially untrue was during the depths of the 2008 financial crisis, and even then, the decrease in prices was limited to transportation and energy costs, while total consumer prices, excluding energy, continued to climb.

What Causes Stagflation?

Economists are far from agreeing on what triggers stagflation. They have put out numerous reasons to explain how it happens, even though it was originally believed impossible.

Oil Price Shocks

A drop in economic output may be one cause of stagflation, which is thought to occur when the price of oil suddenly rises. Consider the oil shortage that hit in the ’70s as an extreme case. The embargo was declared by OPEC (the Organization of Petroleum Exporting Countries) in October 1973. This resulted in a significant increase in the cost of oil worldwide, which in turn increased the prices of commodities and contributed to the rise in the unemployment rate.

When production and distribution expenses went up as a result of rising fuel prices, prices went up and more employees were laid off at the same time. Detractors of this idea point out that none of the times of inflation and recession that have occurred since the embargo have been accompanied by unexpected spikes in oil prices like those in the 1970s.

Subpar Economic Policies

Stagnation and inflation may both be the effect of bad economic policy, another hypothesis suggests. Stagflation is sometimes blamed on too strict control of markets, products, and labor in an inflationary economy.

It has been suggested that the actions of former president Richard Nixon contributed to the economic downturn of 1970, which some see as a forerunner to subsequent stagflationary times. Nixon tried to curb price increases by imposing taxes on imports and freezing prices and wages for 90 days.

As soon as regulations were loosened, prices rocketed upward, causing economic mayhem. While tempting, this ad hoc explanation for 1970s stagflation does not account for subsequent eras that also saw rising prices and unemployment.

Loss of the Gold Standard

Theories that suggest monetary issues contribute to stagflation are not without merit. Nixon ended the Bretton Woods system that had regulated currency exchange rates by eliminating the last remaining indirect ties to the gold standard. This decision eliminated commodity underpinning for the currency and placed the U.S. dollar and other international currencies on a fiat foundation, abolishing most practical limitations on monetary growth and currency depreciation.

How To Prepare For Stagflation

The growing cost of oil is a key factor in stagflation, therefore we may push policymakers to pursue anti-stagflationary measures at the macroeconomic level, such as attempting to lessen the economy’s reliance on the commodity. Facilitating policies that boost economic development and productivity is also useful.

To this end, deRitis proposes that investors think about the likelihood of “low-grade” stagflation, in which inflation falls to 4% but unemployment climbs to 5%. Assuming the Fed is still dedicated to battling inflation, there may be calls for it to also focus on achieving full employment. Since this is the case, it may implement a more lenient monetary policy that enables inflation to persist beyond its 2% objective for a long time, or perhaps forever.

Bottom Line

Most policymakers and economists agree that the best way to combat stagflation is to rethink what they mean by “inflation” in the context of today’s advanced monetary and financial systems. Inflation, the general trend of steadily increasing prices without corresponding increases in the value of money, is a constant feature of both prosperous and economically unstable eras.

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