Why Is Stagflation Bad for the Economy?

A stagnant economy and high inflation are a killer combo

Recession appears to be knocking on the door again. 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. However, opinions vary on how savage it will be. Some claim a soft, brief recession is in store, whereas others fear we are in for a much harder time.

One topic that has been making the rounds a lot lately is the prospect that we could be heading toward a period of stagflation. This has only happened once before in the United States, back in the 1970s, and it isn’t a pleasant experience.

Key Takeaways

  • Stagflation is a stagnant economy combined with high inflation.
  • Stagflation amounts to a killer combination and can result in an economic downturn in which bills and the cost of living keep rising.
  • These types of economic crises are often caused by big supply shocks and easy monetary policy and last longer than regular recessions because there’s no definitive cure.
  • Normally, when a recession strikes, interest rates are cut to stimulate economic activity. But
    central banks can’t really do that when inflation is soaring.
  • Some economists fear that the U.S. economy is heading for stagflation for the first time since the 1970s.

What Is Stagflation?

Stagflation is a word that is a portmanteau of “stagnant” and “inflation.” It describes a period of low to nonexistent economic growth coupled with rapidly rising prices.

What’s the Difference Between Stagflation and Recession? 

A recession is generally said to be in motion once there have been two consecutive quarters of negative economic growth. Stagflation, on the other hand, is much more open to interpretation, mainly because it is rarer.

A stagnant economy isn’t necessarily one in a recession. The term “stagnant” implies sluggish and lacking activity, which could mean a full-blown downturn or just very weak growth. The level of inflation isn’t defined either, although we can assume it has to be at least above the 2% threshold set by most central banks in advanced economies.

Two more key differences are time and frequency. Recessions are considered a normal part of the economic cycle, happen quite often, and historically last just under a year. Stagflation, meanwhile, is uncommon and, when it does rear its ugly head, tends to stick around. These types of economic crises are difficult to defeat because the traditional play of lowering borrowing rates to stimulate growth is taken off the table.

Normally, high inflation is associated with economic growth and can be culled by hiking interest rates. Stagflation is a different kind of animal that’s harder to tame.

What Causes Stagflation?

Based on the few examples we have witnessed so far, it’s generally agreed that the main cause of stagflation is a major supply shock. Should the supply of food, oil, or something else that’s essential be disrupted and become no longer able to meet demand, things tend to get off-kilter. Usually, the situation is then made worse by poor economic policies.

Supply shocks lead prices to rise, hurting businesses, consumer finances, and economic growth. And when central banks respond as they normally do to economic turmoil by making sure money is cheap to borrow, they essentially feed the flames of inflation, stimulating demand and pushing prices up further.

The term “stagflation” was first used in 1965 by British politician Iain Macleod.

History of Stagflation

To date, the U.S. has only once experienced a serious case of stagflation: in the 1970s.

1970s

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.

It took very high interest rates and a nasty recession to restore order. And, as you can probably imagine, the stock market got crushed.

Will Stagflation Return in 2023?

Today, there are fears that a similar situation could unfold again. Inflation is unusually high, and the economy is, well, not exactly firing on all cylinders.

How did we find ourselves in this situation? A combination of unique, random factors is mainly to blame. First, there was the COVID-19 pandemic, which led to a lockdown and a halt in production followed by surging demand once restrictions were lifted. Then Russia invaded Ukraine, causing yet more supply chain issues and leading oil prices to spike. And to top it all off, each of these unlikely, destabilizing events occurred when interest rates were historically low and money was extremely cheap to borrow.

Other factors in some way contributing to today’s stagflation include high debt, protectionist trade policies, an aging population, geopolitical tensions, climate change, and cyber warfare. And some of these aren’t going away, meaning stagflation could be here to stay for a while.

Technically, the economy is not in a recession. However, most economists now agree that the one thing missing, higher unemployment, could soon become a reality as loftier costs to service debt tempt companies to lay off employees. Match lots of people out of work and sluggish economic growth with high inflation, and you have stagflation.

So, are we doomed? Not necessarily. Economist Nouriel Roubini is convinced that the Federal Reserve and other central banks’ attempts to curb inflation will lead to a hard landing and a grueling stagflationary debt crisis. However, his opinion isn’t shared by everyone. Stanford economist John Cochrane, for example, is hopeful that inflation likely will go away and the risk of stagflation will be averted.

At this point, a lot depends on the effectiveness of interest rate rises curtailing demand and whether major supply shocks can be ironed out quickly. If inflation doesn’t ease soon, then the U.S. and global economies could face more than just a regular recession.

When the economy is heading toward recession, central banks ease monetary conditions. They can’t do that now, though—inflation is high, and that’s potentially very worrying.

Why Is Stagflation Bad for the Economy?  

Stagflation is a combination of three negatives: slow economic growth, higher-than-normal unemployment, and expensive cost of living. Whichever way you look at it, that situation is going to be painful.

Usually, to get companies hiring again and the economy back up and running, interest rates are cut. But when inflation is soaring, that action is dangerous, so you are left with people and companies strapped for cash while having to worry about higher prices to service their debts and obligatory purchases costing more and more each week or month.

This is not only an extremely uncomfortable environment to live in but also quite tricky for governments to fix. With no easy cure, stagflation can drag on for years, causing heavy damage to the economy.  

Stagflation can make a regular recession seem like a walk in the park. 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.

Should we soon find ourselves in this situation, the consequences could be catastrophic. As Roubini points out, private and public debts are much higher than in the past, accounting for about 350% of global gross domestic product (GDP) because interest rates were low for ages. Now that this is changing, a storm is brewing, with higher borrowing costs threatening to push leveraged households, companies, financial institutions, and even governments into bankruptcy and default.

If events pan out as Roubini envisions, we could soon find ourselves in an economic crisis like no other, with 1970s-style stagflation potentially being accompanied by a debt meltdown similar to the 2008 Great Recession. Just the thought of a mixture of these downturns, two of the worst on record, is enough to send shivers down the spine, Roubini writes.

Is stagflation worse than a recession?

Yes. Stagflation is basically like a recession with the added headache of rising prices and costs to service debt. And as there is no definitive cure, it is harder to defeat and can last a long time.

Is it good to buy a house during stagflation?

That’s a tough question. If prices continue to rise, it could make sense to buy now rather than wait. However, lackluster economic growth might also weigh on house prices, while the high interest rates needed to combat inflation will mean less favorable borrowing terms. A lot depends on individual circumstances, what rate you’re offered, and how long peak inflation persists—which is anyone’s guess right now.

What investments perform best during stagflation?

Not many traditional asset classes fare well in that kind of environment. The best performers probably will be those with inflation-hedging characteristics, such as inflation-indexed bonds, gold, and possibly real estate.

The Bottom Line

Many of us will have experienced what living in a stagnant economy is like but will be unfamiliar with stagflation. Judging by its criteria and accounts from the 1970s, everyone would be better off if it remains history.

Imagine living in an economic downturn where people are losing their jobs while bills and the cost of living keep on rising. Stagnant growth and high inflation are a killer combo that can do great damage to an economy and leave scars for decades to come.

Article Sources
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  2. Federal Reserve System. “FAQs: Why Does the Federal Reserve Aim for Inflation of 2 Percent Over the Longer Run?

  3. National Bureau of Economic Research. “U.S. Business Cycle Expansions and Contractions.”

  4. Brookings Institution. “Today’s Global Economy Is Eerily Similar to the 1970s, but Governments Can Still Escape a Stagflation Episode.”

  5. U.K. Parliament. “Economic Affairs: Volume 720: Debated on Wednesday 17 November 1965.”

  6. Federal Reserve History. “Oil Shock of 1973–74.”

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  8. Economic Research, Federal Reserve Bank of St. Louis. “The Great Inflation: A Historical Overview and Lessons Learned.”

  9. Macrotrends. “Dow Jones—DJIA—100 Year Historical Chart.”

  10. Time. “We’re Heading for a Stagflationary Crisis Unlike Anything We’ve Ever Seen.”

  11. U.S. Bureau of Economic Analysis. “Gross Domestic Product (Second Estimate) and Corporate Profits (Preliminary), Third Quarter 2022.”

  12. Stanford University News. “Recessions Are Difficult, but Stagnant Growth Could Prove More Challenging, Stanford Economist Warns.”

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