What is stagflation? A double whammy of headwinds

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Economic stagnation + inflation = OUCH!

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When it comes to understanding how monetary policy works, many of us understand, and even expect, the simplified version: The Federal Reserve lowers interest rates to rev up the engines of economic growth, and it raises interest rates to slow the economy when prices start overheating.

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. 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.

But the economy is not mechanical. It’s very nuanced—not all of its “moving parts” are controllable or manipulable, and they definitely don’t react in real time. Sometimes things can go very wrong. What if inflation didn’t arrive with an economic boom and high employment? What if inflation brought with it, instead, a stagnating economy coupled with high unemployment, aka “stagflation”? Which proverbial interest rate button does the Fed push?

The term stagflation is a portmanteau of the words stagnation and inflation.

Stagflation is like the worst of both worlds, and there’s no easy fix to this monetary nightmare.

Stagflation doesn’t respond to the conventional monetary tools based on the Phillips curve (see figure 1). According to the classic theory, when inflation is high, unemployment is supposed to be low, and vice versa.

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.

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Figure 1: CLASSIC ECONOMICS. The Phillips curve plotted as unemployment versus CPI.

Retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/UNRATE, https://fred.stlouisfed.org/series/CPIAUCSL, August 24, 2023. Annotations by Encyclopædia Britannica. For educational purposes only.

Stagflation is uncommon, but it has happened a couple times in the last several decades. The most notable case of stagflation took place in the 1970s, afflicting most Western economies.

Although economists can point to multiple factors that may have caused stagflation in the 1970s, many of which remain in debate, economists frequently call out two in particular:

In 1980, the Federal Reserve, led by chair Paul Volcker, raised the Fed funds rate to as high as 21%. This led to a painful 16-month recession and spike in the unemployment rate to 10.8%. But the bitter medicine fixed the economic malady. Considering that stagflation is such an unusual and puzzling condition, there’s no guarantee that such an austerity fix would produce the same results in another stagflationary situation.

There were signs of possible stagflation during the early 2020s, but as economists and analysts know, it’s much simpler to define trends and eras in the rearview mirror than in real time. 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.

However, aside from a brief but severe recession due to the pandemic lockdowns in 2020, the economy muddled through, with gross domestic product (GDP) mostly positive and relatively steady.

It depends on the nature of the stagflationary condition. Gold performed well in the 1970s, as it and other precious metals are seen as a traditional hedge. Commodities also performed well, particularly oil (of course, there was an embargo) and other commodities of limited supply. Real estate also served as a good hedge, as it was less correlated to stocks.

Rental properties would have made sense in the 1970s, but in the post-pandemic inflationary period, rental property investing was a tricky business. On the one hand, housing prices (and average rent prices) rose on an annualized basis, but many cities and states implemented eviction moratoriums (meaning you couldn’t evict tenants who weren’t able to pay their rent).

Stagflation is a double whammy of economic woes that combines lethargic economic growth (and, typically, high unemployment) with escalating inflation. It’s also a conundrum for fiscal and monetary policymakers, as it turns the Phillips curve on its head. Although the U.S. eventually overcame the stagflation scourge of the 1970s—after a decade of economic doldrums—the causes of stagflation and the best solution for overcoming it remain a matter of debate.

Although the three decades following the last stagflation cycle were marked by moderate inflation and an extended bull market in stocks, anyone who lived through the twin recessions and abnormally high interest rates of the early 1980s knows that, with stagflation, the cure can be as painful as the disease.