What Is Stagflation, What Causes It, and Why Is It Bad?

9 December, 2022

Macleod used the term again on 7 July 1970, and the media began also to use it, for example in The Economist on 15 August 1970, and Newsweek on 19 March 1973. John Maynard Keynes did not use the term, but some of his work refers to the conditions that most would recognise as stagflation. In the version of Keynesian macroeconomic theory that was dominant between the end of World War II and the late 1970s, inflation and recession were regarded as mutually exclusive, the relationship between the two being described by the Phillips curve. Usually, to get companies hiring again and the economy back up and running, interest rates are cut.

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. 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.

1. This decision removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a fiat basis, ending most practical constraints on monetary expansion and currency devaluation.
2. He says that’s because the economy is fundamentally different today than it was back then.
3. 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.
4. According to the classic theory, when inflation is high, unemployment is supposed to be low, and vice versa.
5. When businesses are struggling to turn a profit, earnings expectations fall and with them, stock prices.

“At the same time, inflation reduces the purchasing power of households and consumer confidence declines, further impacting economic growth,” he says. “In such economic conditions, businesses and individuals face difficulties in planning and making investment decisions.” Should we soon find ourselves in this situation, the consequences could be catastrophic.

President Richard Nixon tried to mitigate 1970s stagflation by devaluing the dollar and declaring price and wage freezes. However, that strategy did not work and is considered among the great failures of American macroeconomic policy by Jeremy Siegel, a prominent economist. Many economists now believe that the growth of the money supply by the Federal Reserve was the main factor in the stagflation crisis of the 1970s. 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.

End of the Gold Standard

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 https://www.day-trading.info/a-day-in-the-life-of-a-day-trader-episode-121-day/ economics, portrayed macroeconomic policy as a trade-off between unemployment and inflation. Stagflation is an economic cycle characterized by slow growth and a high unemployment rate accompanied by inflation.

How to invest during stagflation

For those who invest in growth stocks, there could be significant losses as many investors may have expected growth targets that stagflation would make it harder to meet. That is easier said than done, so the key to preventing stagflation is for economic policymakers to be extremely proactive in avoiding it. Because transportation costs rose, producing products and getting them to shelves became more expensive and prices rose even as people were laid off from their jobs. In addition to the World Bank, other major institutions—like Goldman Sachs and BlackRock—also warned about stagflation risks. And former Fed Chair Ben Bernanke said in May 2022 that the U.S. could be in for a period of stagflation.

Responses to Stagflation

In June 2022, Forbes magazine argued that a period of stagflation was likely because economic policymakers would tackle unemployment first, leaving inflation to be dealt with later. In the decades since, there hasn’t been a time when those three factors—high inflation, slow economic growth, and a rapid rise in unemployment—occurred simultaneously and for a prolonged period. During a recession, policymakers can turn to expansionary monetary and fiscal policies to stimulate the economy, but these same policies exacerbate the inflationary side of stagflation. And since inflation is generally experienced by a wider share of the public than job loss, as Steven Wieting, chief investment strategist at Citi Global Wealth Investments, points out, this can lead to a great deal of hurt.

If you want more tactical advice, consider overweighting defensive stocks in sectors such as consumer staples, utilities, energy and healthcare, Brochin says. Businesses in these sectors tend to have more stable earnings, https://www.topforexnews.org/investing/12-best-investments-for-any-age-or-income-3/ which can provide some protection against stagnant economic growth and inflation. “In particular, we believe investors should favor companies with pricing power that are able to pass increased costs to consumers.”

As we normally understand the economic cycle, economic growth comes with an increase in jobs and, eventually, a rise in the price of goods and services, aka inflation. (The Fed’s target for “healthy” inflation is around 2%.) In contrast, when the economy slows, the job market begins to contract, and inflation also cools. the inverse relationship between bond prices and bond interest rates It seems like a simple solution—lowering/raising interest rates to stimulate or slow down the economy, as if all the central bank has to do is flip a switch. Economist Friedrich Hayek proposed that governments fight inflation by ending expansionary monetary policies and waiting for prices to adjust via the free market.

Nominal factors like changes in the money supply only affect nominal variables like inflation. The neoclassical idea that nominal factors cannot have real effects is often called monetary neutrality[32] or also the classical dichotomy. The cost-push inflation theory sees supply-side inflation as a key driver of stagflation. In this case, rising prices lead to unemployment since they usually reduce profit margins for companies which leads to reduced economic output.

Stagflation can sometimes correct over time and interventions to try to end it could lead to recessions with dramatic declines in GDP. 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. She believed that to avoid the phenomenon of stagflation, a country needed to provide an incentive to develop “import-replacing cities”—that is, cities that balance import with production. This idea, essentially the diversification of the economies of cities, was critiqued for its lack of scholarship by some, but held weight with others. They have put forth several arguments to explain how it occurs, even though it was once considered impossible.