Finance

What Is Stagflation? Should I Be Worried About It?

Sometimes, combining two things can make something great; other times, the result can be less than ideal. The concept of stagflation is a case in point, as it amalgamates two already worrisome economic scenarios to create a situation with the worst features of both.

While stagflation isn’t pleasant when it happens, learning about it shouldn’t be such a scary proposition. As we unpack stagflation and consider some historical examples of it, we can better understand its significance while, hopefully, preparing for what could at some point happen again.

The “Flation” in Stagflation

So, let’s start at the beginning: What is stagflation, anyway?

Stagflation is a compound concept that combines a stagnant economy (i.e., a recession) with high inflation.

So, when considering stagflation vs. inflation, just remember the idea of set and subset: Stagflation by definition involves inflation, but inflation doesn’t usually include recessionary conditions, so not all inflation involves stagflation.

Since we have one word and two separate but sometimes related concepts here. Perhaps it’s best to start with the second concept first: inflation.

In its most basic terms, inflation describes an increase in the prices of the things we buy. This creates an effective decline in the value of the money you’re using: the same amount of money buys less.

Inflation, at least in the U.S., is typically expressed as a percentage. How much did the prices of commonly purchased goods increase, compared to where they stood a year ago? This is calculated using the growth rate in the Consumer Price Index, or CPI. This is provided each month by the Bureau of Labor Statistics (BLS) – the same government agency that also provides monthly unemployment figures, but we’ll touch upon that in a moment.

So, if the August 2022 CPI growth rate was 8.3%, that’s how much more expensive food, fuel, shelter, and other essential products generally cost in America compared to August 2021. The Federal Reserve, which moderates the flow of U.S. dollars to the nation’s big banks, prefers to see the rate at 2%, so the 8.3% figure is an expression of unusually high inflation.

In other words, the “-flation” in stagflation isn’t just inflation; it’s unusually elevated inflation in a particular geographic region, compared to its usual or expected rate. Thus, inflation, and therefore stagflation, only makes sense within a specific context.

When the Economy Loses Its Flow

Then, there’s the other part of stagflation: the stagnant economic conditions.

If stagnant waters are ones that aren’t flowing like they ought to be, then a stagnant economy similarly isn’t advancing or developing. The money isn’t flowing throughout the economy because people aren’t buying products like they would during a more robust economy. And, when people cut back on purchases, businesses suffer and sometimes, this leads to a deep, persistent regional economic downturn commonly known as a recession.

Technically, the U.S. isn’t in a recession until a non-profit institution called the National Bureau of Economic Research (NBER) calls the current economic conditions a recession. There’s no numeric formula provided for this; rather, the NBER characterizes a recession as involving a “significant decline in economic activity that is spread across the economy and lasts more than a few months,” with such factors as “real personal income less transfers, nonfarm payroll employment, employment as measured by the household survey, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, and industrial production” taken into consideration.

Most likely, the NBER didn’t declare a recession in August of 2022 despite the high inflation rate because, at that time, U.S. unemployment was relatively low at 3.7% of the measured population[1]. This was determined by a government entity that’s already familiar to you now: the BLS.

In contemplating what causes stagflation, then, one must consider an interrelated web of unfortunate factors.

If inflation remains persistently high, this could lead to recession and therefore stagflation if the inflation crimps spending and borrowing activity – two linchpins of a robust, thriving economy. This, in turn, could lead to hiring freezes and layoffs, which would typically be reflected in a rising unemployment rate – another telltale sign that the country may be entering into a recession and/or stagflation.

When Opposites Combine

Under normal conditions, inflation and stagnation are opposites that we wouldn’t expect to see at the same time.

Inflation occurs when there are too few goods and services available to buy – too much money chasing too few goods – and buyers bid the prices of goods up. The natural response for producers is to make more goods, which tends to cut unemployment. Inflation is typically a sign of an overheated economy, where demand exceeds supply.

Recessions typically occur when demand for goods is low. Consumers stop buying, manufacturers cut back, and unemployment increases. A recession is normally a deflationary condition, where the economy cools off.

Stagflation brings these two natural opposites together. This can happen in some circumstances, but it’s relatively unusual.

Stagflation in the 1970s: An Imperfect Storm of Adverse Conditions

There have been notable historical examples of stagflation throughout the ages, including Japan’s so-called “lost decade” of the 1990s (though of course, that example was outside of the NBER’s purview to officially declare it recessionary). In the U.S., however, people typically think of the nation’s economic conditions during the 1970s as the definitive example of stagflation.

What caused stagflation in the 1970s? As usual, it’s difficult to pinpoint a specific incident that sparked the stagflationary chain reaction. One contributing factor may have been the Nixon administration’s “closing of the gold window”: the U.S. dollar, once pegged to gold, was now declared valuable by fiat or government decree. This enabled the government to print and spend money more freely, which evidently led to an oversupply of dollars and hence the devaluation of those dollars.

The actual impact of this may have been less than some speculate. Between the cost of the Vietnam War, Johnson’s “Great Society” programs, and foreign banks effectively creating dollars by lending more than they had in reserve, the dollar supply had far outrun US gold reserves well before Nixon formally dropped the link.

There were certainly other, concurrent contributing factors, not the least of which was high gasoline prices prompted by OPEC member nations constraining the flow of petroleum to the U.S.

By the end of the decade, stagflation was a household term: U.S. inflation approached 14.5% and unemployment topped 7.5% during the summer of 1980[2].

In hindsight, we can take cues on how to beat stagflation from the Paul Volcker-chaired Federal Reserve of the early 1980s. The Federal Reserve deliberately slowed down the economy by raising the nation’s benchmark interest rate to very high levels, plunging the U.S. into a painful recession but eventually suppressing inflation to a more manageable level. Without the high inflation rate, money could flow more freely throughout the economy, and stagflation was tamed.

It’s Not Always About Policy

We tend to think of economic events as products of government policy, but there’s a lot that happens in the economy that does not involve the government.

Another factor driving 1970s stagflation involved demographic shifts: the primary economic activity of the American family at that time was putting the baby boomers through college, which involved large expenditures without production and greatly constrained demand.

Beginning in the late 70s and early 80s, the bulk of the baby boom was moving out of college and getting their first jobs and their first credit cards. At the same time their parents, who were still in the workforce, began catching up on the buying they’d put off while the kids were in college.

That surge in demand had a major impact on reducing stagnation, but why didn’t it push higher inflation?

Part of the answer is that US imports grew from $294 billion in 1980 to $630 billion in 1990, providing a rising supply of lower-priced goods to soak up the new spending power that was driving the economy out of stagnation.

Economies are complicated and there’s almost never a single cause for their movements!

Take a Vacation From the Fear of Stagflation

The term “stagflation” reappeared in public discourse in 2022. Economic growth has been largely stagnant, debt levels are high, and an asset bubble is unwinding, all conditions we usually associate with recession.

At the same time inflation has reached levels not seen since the early 1980s, driven largely by production and supply chain disruptions that have kept goods off the market and kept consumers bidding for a limited supply of goods.

So is it stagflation?

Not quite. Inflation is real and there are signs of stagnation, but unemployment remains extremely low and production continues to recover. There is a chance that the economy will sink into recession, but economists expect that a recession would bring inflation rates down.

It’s possible that inflation could remain elevated even as the economy slows, generating 1970s-style stagflation, but that’s a possibility, not a certainty.

Among the important takeaways from the example of the 1970s is that, no matter how bad stagflation may get, it will always come to an end sooner or later. The damage will be done, but nations eventually heal and people put their lives back together.

Some nations have also responded to economic crises in very destructive ways. This typically occurs not because of the economic dislocation, but because people respond to the dislocation by embracing extremist political ideologies, often leading to internal or external conflict. As long as nations remain strong and keep to their principles they usually recover and prosper.

So, there’s no need to obsess over whether we’re in a period of stagflation right now or whether we’re about to enter into stagflation. Instead, we can choose to learn from history’s vital lessons and evolve as nations so that hopefully, we can avoid the errors of generations past.


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