What stagflation means and why it matters

what is stagflation

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. Even before the 1970s, some economists criticized the notion of a stable relationship between inflation and unemployment. They argue that consumers and producers adjust their economic behavior to rising price levels either in reaction to—or in expectation of—monetary policy changes. Cost-push inflation reflects a rise in prices of one or more key economic inputs, such as crude oil, grain, or labor. Cost-push inflation results when producers are able to recoup their increased costs by increasing the price of finished products.

According to this theory, periods of mergers and acquisitions oscillate with periods of stagflation. When mergers and acquisitions are no longer politically feasible (governments clamp down with anti-monopoly rules), stagflation is used as an alternative to have higher relative profit than the competition. With increasing mergers and acquisitions, the power to implement stagflation increases. The wage-price spiral, sometimes also called wage-push inflation or built-in inflation, describes instances when rising wages and prices reinforce each other, with higher prices driving wage increases which then result in still higher prices. The wage-price spiral is what can happen when policymakers fail to bring inflation under control.

Attempts to squash unemployment and boost the economy, for example through added public spending or very low interest rates, risks generating inflation. Inflation and unemployment are supposed to have an inverse relationship, making it easier for central banks to manage things by adjusting interest rates. But if this is how the economy is supposed to work, stagflation is a puzzling paradox. And it forces central bankers and policymakers to devise new ways to solve the problem.

Policymakers today are also more attuned to inflation than they were four decades ago. Most central banks today have numerical targets, making it less likely they will miss runaway inflation and allow it to become “anchored” among consumers. Meanwhile, the economy continues to show resilience, even if the underpinnings of growth appear more fragile. Consumers continue to spend at a healthy clip despite higher prices and businesses continue to hire. Turning the current inflation problem into stagflation would require two further ingredients.

what is stagflation

First, inflation would have to become persistent, so that the economy adjusts to accept and expect a higher rate of inflation each year. That only happens if central banks are willing to tolerate it for long enough that expectations of workers, firms and investors shift. Germany’s Bundesbank stopped inflation becoming entrenched by stepping on the brakes early and committing itself firmly to stable prices.

The steepest inflation in four decades and severe product shortages have evoked comparisons to the economic doldrums faced by the U.S. in the 1970s. The echoes are reviving concerns about “stagflation,” a term coined during that earlier period that has become synonymous with double-digit price increases, job losses and images of motorists queueing for gasoline. When weighing big purchasing decisions—like a car, for example—consider whether you can defer or delay the purchase of items where prices may be temporarily elevated, he adds. This is an unexpected event, such as a disruption in the oil supply or a shortage of essential parts. Such a shock occurred during the COVID-19 pandemic with a disruption of the flow of semiconductors that slowed the production of everything from laptops to cars and appliances. Some point to former President Richard Nixon’s policies, which may have led to the recession of 1970—a possible precursor to other periods of stagflation.

Excess demand

The high inflation leaves less scope for policymakers to address growth shortfalls with lower interest rates and higher public spending. A wage-price spiral seemed improbable for decades after Paul Volcker’s Fed tamed inflation in the early 1980s, bringing stagflation to an end. In the aftermath of the 2007 to 2008 Great Recession and financial crisis and until 2021, inflation mostly fell short of the Fed’s targets amid lackluster economic growth. And if price increases stay high for long enough, consumers could begin to expect constantly rising prices as the new normal and will change their behavior accordingly, creating a self-fulfilling inflation cycle.

Inflation decreases the number of goods or services you can purchase for a set amount of money, lowering purchasing power. What’s indisputable is that it took a pair of painful recessions to bring down inflation for good and legislation enacting larger U.S. budget deficits and economic deregulation to revive growth during Ronald Reagan’s presidency. They also seek to understand what’s causing inflation, because inflationary impulses come in several distinct types, each with its own cause and consequences. Three key varieties are demand-pull inflation, cost-push inflation, and wage-price spiral inflation, the latter also known as built-in inflation. The risk is that the Fed’s rate hikes end up quashing growth, rather than merely dialing it back, triggering a recession.

While appealing, this is an ad-hoc explanation of the stagflation of the 1970s which does not explain later periods that showed a simultaneous rise in prices and unemployment. The economic theories that dominated academic and policy circles for much of the 20th century ruled it out of their models. In particular, the economic theory of the Phillips Curve, which developed in the context of Keynesian economics, portrayed macroeconomic policy as a trade-off between unemployment and inflation. The term stagflation was first used by British politician Iain Macleod in a speech before the House of Commons in 1965, a time of economic stress in the United Kingdom. He called the combined effects of inflation and stagnation a “‘stagflation situation.” As noted above, central banks like the Federal Reserve, often referred to as the Fed, and the European Central Bank (ECB) prefer modest inflation to none at all, as insurance against destabilizing deflation.

The demand for gas did not change but the lack of supply raised the price of gasoline to $5 a gallon. Erika Rasure is globally-recognized as a leading consumer economics https://www.forex-world.net/ 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.

What is stagflation?

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. Since that time, inflation has proved to be persistent even during periods of slow or negative economic growth. In the past 50 years, every declared recession in the U.S. has seen a continuous, year-over-year rise in consumer price levels. In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment. High prices squeeze household budgets and reduce consumer spending, while weak economic activity means businesses grow slowly, if at all, and corporate profits slump.

  1. 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.
  2. Urbanist and author Jane Jacobs saw the disagreements between economists on the causes of the stagflation of the ‘70s as a misplacement of scholarly focus on the nation rather than the city as the primary economic engine.
  3. With increasing mergers and acquisitions, the power to implement stagflation increases.
  4. And it forces central bankers and policymakers to devise new ways to solve the problem.
  5. Inflation is the broad rise in the price of goods and services across the economy.
  6. If supply-chain snags were to ease, making cars, electronics, food and fuel more plentiful, prices would fall quickly, said Chester Spatt, professor of finance at Carnegie Mellon University’s Tepper School of Business.

The dramatic episodes of stagflation in the 1970s may be historical footnotes today. But, since then, simultaneous economic stagnation and rising prices appear to be part of the new normal of economic downturns. One theory states that stagflation is caused when a sudden increase in the cost of oil reduces an economy’s productive capacity. This index, a simple sum of the inflation rate and the unemployment rate, tracked the real-world effects of stagflation on a nation’s people. The debate about what caused stagflation in the 1970s features a similar list of prime suspects, from soaring energy prices to the end of managed exchange rates following the collapse of the Bretton Woods system.

What Is the Cure for Stagflation?

Severe supply constraints and labor shortages during the COVID-19 pandemic pushed inflation as high as 9%. Russia’s invasion of Ukraine and—in a repeat of history—production cuts by OPEC kept oil and fuel prices high. The de facto consensus on stagflation among most economists and policymakers has been to essentially redefine what they mean by the term inflation in the era of modern currency and financial systems.

This caused the global price of oil to rise dramatically, therefore increasing the costs of goods and contributing to a rise in unemployment. Typically, inflation is coupled with economic growth and can even be a byproduct of a rapidly expanding economy. Stagflation refers to the rare and puzzling phenomenon of a recession coinciding with prolonged high inflation. Stagflation marked the worst performance by advanced economies between the Great Depression https://www.currency-trading.org/ and the Great Recession, and as such left a lasting mark. It led economist Arthur Okun to come up with a misery index summing the inflation and unemployment rates, and the name encapsulates how that period of economic history is remembered. The causes of stagflation during that period remain in dispute, as did the likelihood of a reprise in 2022 amid high energy and food prices, rising interest rates, and persistent supply-chain snags.

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. The explanation for the shift of the Phillips curve was initially provided by the monetarist economist Milton Friedman, and also by Edmund Phelps. Both argued that when workers and firms begin to expect more inflation, the Phillips curve shifts up (meaning that more inflation occurs at any given level of unemployment). While this idea was a severe criticism of early Keynesian theories, it was gradually accepted by most Keynesians, and has been incorporated into New Keynesian economic models. So far this year, the Fed has increased its target interest rate twice, and it appears ready to hike it at least three more times before the end of 2022. Higher borrowing costs have already had an effect on the housing market, with mortgage rates rising from about 3% in January to 5% today.

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Other theories point to monetary factors that may also play a role in stagflation. They have put forth several arguments to explain how it occurs, even though it was once considered impossible. Once thought by economists to be impossible, stagflation has occurred repeatedly in the developed world since the 1970s oil crisis. Economic conditions in early 2022 led many commentators https://www.forexbox.info/ 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. Cost-push inflation occurred in 2005 after Hurricane Katrina destroyed gasoline supply lines in the region.

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