Stagflation Defined: Risks, Causes, and Cure

Stagflation is a rare economic phenomenon that combines two or three negative economic trends that normally do not occur together: high inflation, poor growth and rising unemployment. It has only occurred two or three times in the past 100 years. For example, during the global 1970s stagflation period, Australia saw unemployment skyrocket 1973 and 1983, with the jobless rate tipping over 10%.

But when stagflation does arrive, it is very hard to overcome because the monetary policy tools typically used to defeat one of those trends tend to make the others worse. Stagflation can create so much misery for the people living through it that economists actually call one tool they use to measure it the “Misery Index.”

During early 2022, as this article was being prepared, inflation was high and economic growth was slowing, setting the stage for stagflation’s potential return.

What Is Stagflation?

“Stagflation” is a portmanteau word combining “inflation” and “stagnation.” An economy in stagflation has high consumer price inflation, low economic growth and sometimes rising unemployment, as typically high inflation is accompanied by low unemployment The word was coined by the British politician Iain Macleod in 1965 to describe the state of the U.K. economy at that time; it was subsequently used in reference to the global economic crisis in the 1970s. Stagflation is highly unusual because high inflation and low economic growth are contradictory trends — inflation, by its nature, typically occurs alongside economic booms.

Stagflation vs. Inflation: Inflation is defined as a rise in the general level of consumer prices. Stagflation is the combination of generally high and rising consumer prices with low, absent or even negative economic growth.

Key Takeaways

• Stagflation is the combination of high consumer price inflation and stagnant economic growth, sometimes accompanied by rising unemployment.
• It can be caused by a supply-side shock, such as sharply rising oil prices, or by poor economic policies, such as too-high government spending or too-low interest rates.
• A wage-price spiral is typical of stagflation caused by poor monetary policy.
• The “Misery Index,” which combines inflation and unemployment, is a measure of stagflation.
• The best-known example of stagflation occurred during the global economic crisis in the 1970s. Other examples include the period after the 2008 global financial crisis.
• Curing stagflation can be difficult if it has become entrenched.

Stagflation Explained

It’s possible for an economy to have both high inflation, as measured by a country’s own Consumer Price Index (CPI), and strong economic growth, measured in terms of gross domestic product (GDP). This typically happens in developing nations with young populations, or can be caused by government stimulus. For example, governments in Australia, New Zealand, Singapore and Hong Kong provided substantial spending packages to stimulate the economy during the pandemic. Post-pandemic, all of these nations are now experiencing both increasing inflation and economic growth. It’s also possible for an economy to have neither CPI inflation nor GDP growth, as has been the case in Japan for over a quarter of a century. Neither of these conditions is stagflation.

For there to be stagflation, there must be both CPI inflation and poor or absent GDP growth. It’s even possible for a stagflationary economy to be in recession, which means GDP growth is negative despite high inflation. This happened to many Asia Pacific (APAC) economies in the mid-1970s. For example, in New Zealand in 1975 the GDP growth rate was -1.7% however the inflation rate was 14.7%. This was an after-effect of the oil price spike in 1973, which slowed down growth in industrialisation and also impacted the demand for New Zealand’s exports. In some recorded instances, stagflation is accompanied by rising unemployment.

How Does Stagflation Work?

Stagflation combines inflation, which lowers the purchasing power of money, with poor productivity, which lowers economic growth. It has been described as causing “misery” because the money people have buys less and less, causing their real cost of living to rise, while the economy’s low productivity and high unemployment prevent their wages from rising to compensate. Stagflation erodes people’s income and savings while causing businesses to hold down wages and hold back on investments and hiring.

In the early 1970s the American economist Arthur Melvin Okun invented the so-called “Misery Index,” which measures the economic distress stagflation causes when inflation and unemployment combine.

What Causes Stagflation?

Economists identify two main causes of stagflation: supply-side shock and poor economic policies. These events can occur independently, but they can also occur together and reinforce each other.

• Supply-side shock. This is typically a sharp rise in the global price of some essential commodity, such as oil. Oil is a good example because higher oil prices increase costs for virtually all businesses. In turn, businesses typically pass higher costs on to consumers in the form of rising prices and to workers in the form of lower wages and/or layoffs. As a result, both inflation and unemployment rise. Falling real incomes force households to cut back spending, particularly on nonessential goods and services, which causes economic growth to slow or fall. In response, businesses reduce output to maintain the high prices needed to cover the cost of the oil price shock. In this scenario, the fundamental cause of the stagflation is the oil price shock; unemployment and/or under-employment, falling real incomes and stagnant output are the result.

  For example, in Singapore, higher oil prices drove inflation to almost 20% in 1973 and approximately 30% in the first half of 1974, and the GDP growth rate fell from 10.6% in 1973 to 6.1% in 1974.

  Supply-side shock inflation typically dissipates when commodity prices stop rising, though because commodity contracts typically have long lead times, the price shock can take a year or more to unwind. Supply chain disruptions, such as what happened in the COVID-19 pandemic, can also cause stagflation. Sharp rises in shipping, railroad and haulage costs can be passed on to customers and workers in the same way as commodity price shocks. Even if the shock itself is transitory, the ensuing stagflation can take a year or more to unwind due to long lead times on shipping contracts.

• Poor economic policies. Stagflation can be caused by inappropriate monetary and/or fiscal policy. For example, a government might increase taxes on businesses, sharply raise the minimum wage and/or increase social spending. Employers facing a “double whammy” of higher taxes and higher labour costs could raise prices for consumers, thus increasing inflation. Alternatively, a government/central bank might keep interest rates too low in an economy running close to full capacity, triggering a consumer boom that drives prices higher. Workers demand higher wages in anticipation of higher prices; employers agree to their demands without insisting on higher output to counter the increased labour costs because they expect to be able to pass those costs on to customers in the form of higher prices. Consumer prices thus rise, resulting in more wage demands. This is known as a “wage-price spiral.” Prices rise, wages rise but output stays flat, and unemployment rises among young people entering the workforce and those with casual or insecure jobs.

  In the early 1970s, government policy frameworks were centred on driving down employment and strong economic growth in Australia. However, the oil shock of 1973 caused prices to skyrocket. By 1974, CPI inflation had reached 15.83% and Australia was in a recession. By 1975, gross domestic product (GDP) growth rate was only 1.3%. Similar events occurred in other APAC nations.

Why Is Stagflation Bad?

Stagflation is particularly bad because it combines two situations that are normally contradictory, namely rising prices and falling economic output. This squeezes the citizens in an economy experiencing stagflation because their real buying power diminishes and their salaries — and savings — stagnate or decline in value.

Exacerbating the situation is that stagflation creates difficulties for policymakers: Policies that could cure inflation are likely to worsen economic output, and vice versa.

Is Stagflation Curable?

Mild stagflation caused by a supply-side shock such as an oil price rise, may cure itself once the supply-side shock passes. But other forms of stagflation can be difficult to cure.

Cutting government spending can reduce inflation, and reducing taxes for businesses can increase output. But if there is an entrenched wage-price spiral, then expectations of price and wage increases must be broken. This could mean sharply raising interest rates to eliminate the cheap money that drives the spiral. For example, a second spike in the oil price in 1978 prompted such high inflation that the New Zealand government imposed a year-long price and wages freeze in June 1982. Although this temporarily decreased the inflation rate, it was not sustainable.

Signs of Stagflation

The most obvious telltale signs of stagflation are generally macroeconomic, like rising consumer prices, rising unemployment or declining economic growth.

But supply-chain shocks, such as a sudden spike in the price of oil, or global supply-chain disruptions, like those that have come, gone and come back again since the beginning of the COVID-19 pandemic, are also considered key signs because they can lead to stagflation. Similarly, extended periods of loose monetary policy, high government spending or both can portend a period of stagflation.

Examples of Stagflation

The stagflation originally described by Macleod in 1965 was a combination of low economic growth and high inflation, which he attributed to poor productivity, excessive government spending — particularly on subsidies to keep key prices down — and a stubborn trade deficit. A trade deficit happens when imports exceed exports, indicating that the economy is producing less than it consumes.

But by far the most famous example is the global stagflation of the 1970s. In many countries, exchange rate devaluation coupled with high government spending and low interest rates generated a brief economic boom. But that boom quickly foundered as rising inflation and an oil price shock rapidly destroyed productivity and economic output.

History of Stagflation

The story of stagflation begins in the years following World War II, when fast economic growth and full employment were policymakers’ twin goals. Economists who had learned their trade in the Great Depression feared unemployment and recession more than inflation.

In Singapore, the economy began to recover in 1947 following an increasing global demand for tin and rubber. International and domestic trade, productivity levels, and social services were restored to pre-war levels by 1949. At the same time a five-year social welfare plan was implemented. This paid benefits to the elderly, disabled, and to widows with dependent children. Similar events occurred in Australia, where until 1942 the Commonwealth had only paid aged and invalid pensions. By the end of the 1940s it also provided rehabilitation services, unemployment benefits, funeral benefits to pensioners and benefits to university students. The government at the time also paved the way for future federal financing of tertiary education, road building and urban development, seeing an economic and employment boom.

The Phillips Curve model, which posits a trade-off between unemployment and inflation, appeared to show that there could not be inflation while unemployment existed. And so-called “Keynesian” economics, named after the British economist John Maynard Keynes, taught that even at full employment, inflation could be kept low by controlling prices and incomes. So achieving full employment and maximum output appeared to be possible without negative economic consequences — namely, inflation.

But inflation crept up on many APAC economies during the 1960s. Macleod coined his new term, stagflation, in 1965 to describe the U.K.’s rising inflation and persistently poor economic growth. The same events were occurring across APAC nations. There was a demand effect emanating from an overly optimistic view of what could be achieved by active fiscal and monetary policy. These policies strove to achieve unsustainably high rates of growth and employment, leading to the steady rise in inflation.

Two years later, the U.K. government devalued the pound, kicking off an inflationary spiral that eventually resulted in the U.K. and other European nations abandoning the Bretton Woods exchange rate system. Around the same time, Australia and New Zealand respectively abandoned the sterling pound following its devaluation, switching to a decimal currency. In 1973, the OPEC oil-producing countries imposed an embargo on the U.S. and its allies, including Japan, for supporting Israel in the Yom Kippur War. The price of oil skyrocketed, fuelling already-rising global inflation and depressing its output. By 1974, Australia was in recession and had double-digit inflation, with New Zealand closely following. Despite government spending cuts, Australia, New Zealand and Singapore remained in stagflation for the rest of the 1970s.

A second oil price shock occurred from 1979 to 1980, when a revolution in Iran deposed the Shah and its neighbour Iraq then invaded. But by this time, economic wisdom had changed. Despite remaining high inflation, by the mid-1980s, stagflation had been conquered in some but not all APAC nations. The Philippine government attempted to deter the expanding domestic recession by raising expenditure, and made significant plans for industrial investment. However, in contrast to neighbouring countries, their economy did not recover under the impetus of increased investment spending. After central banks adopted inflation-targeting in the early 1990s, inflation largely disappeared from APAC economies. But the ghost of stagflation reappeared after the financial crisis of 2008, when high oil prices squashed a fragile recovery and very loose monetary policy raised consumer inflation.

Stagflation also threatened to reappear in the latter part of the COVID-19 pandemic, as high commodity prices and disrupted supply chains raised producer prices, government unemployment subsidies increased consumer spending, and loose monetary policy made money easy and cheap to obtain. However, the economy grew strongly as it recovered from the pandemic-induced recession, and unemployment fell. Many argued that inflation would prove transitory since it was mainly due to supply-side factors that would resolve themselves in due course.

Conclusion

Stagflation is extremely damaging. It erodes people’s incomes and savings, forces businesses to cut back on investments and hiring, and damages the government’s tax base. And if it becomes entrenched, it can be difficult to cure without considerable economic pain. However, central banks and governments that are alert to the risks can take corrective action before stagflation takes root.

Stagflation FAQs

What is stagflation caused by?

Stagflation can be caused by a supply-side shock, such as a sudden rise in the oil price, or by excessively loose fiscal and/or monetary policy.

What is the difference between stagflation and inflation?

Inflation is rising consumer prices. Stagflation is the combination of rising consumer prices with low, absent or negative economic growth and, usually, rising unemployment.

What caused the 1970s stagflation?

The 1970s stagflation was caused by a combination of factors: high government expenditure, low interest rates, competition in export markets, suspension of the gold standard, two oil price shocks and powerful labour unions negotiating inflationary wage rises.

What are the effects of stagflation?

Stagflation erodes people’s incomes and savings, forces businesses to cut investments and lay off staff, and causes general misery. The so-called “Misery Index,” which sums the rates of inflation and unemployment, is a measure of the misery caused by stagflation.