What is stagflation in economics? (and what are its consequences?)

The short version

• Stagflation occurs when inflation is high but economic growth is flat.
• The last time the U.S. experienced stagflation was during the 1970s oil crisis.
• While we aren’t experiencing stagflation right now, many economists and analysts are worried it could occur in the next year.
• Investors concerned about stagflation might consider investing in commodities, dividend stocks, or a barbell strategy to hedge against the risk.

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What is stagflation in economics?

Stagflation is when high inflation pairs with a weak economy. Usually, when prices soar, it's also a period of high economic growth. When the economy slows, prices tend to fall, and joblessness rises.

The term stagflation was first coined during the 1970s oil crisis. OPEC's 1973 Oil Embargo, a response to the U.S.'s support of Israel and the Iranian revolution in the 1980s, led to soaring energy and gas prices.

This crisis, combined with rising unemployment and easy monetary policy, led the consumer price index to rise 13.5% in 1980. This pushed the Federal Reserve to increase interest rates to 20%, the highest the Fed funds rate has ever been.

What causes stagflation?

There are several theories about what causes stagflation, although economists don’t all agree. In fact, before the 1970s, economists thought that inflation and unemployment were inversely linked. But as history has shown us, the two can exist simultaneously during stagflation.

One theory is that stagflation is caused by a sudden negative supply shock of a major good, like oil. This happened in the 1970s during the oil embargo.

Prices skyrocketed for the high-demand commodity, which is in nearly everything produced today. High oil prices cause businesses to produce less, which means less supply, less output and national growth, unemployment, and higher costs.

Another potential cause of stagflation is poor fiscal and monetary policies. During the oil crisis of the 1970s, Fed Chairman Arthur Burns responded with an easy monetary policy that allowed inflation to soar.

Meanwhile, President Richard Nixon responded by devaluing the dollar and declaring wage and price freezes. While these moves were well-intentioned, some think that they were significant catalysts for the stagflation that the country experienced in the 1970s.

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What are the consequences of stagflation?

The first consequence of stagflation is a reduction in economic growth. Higher interest rates makes it more difficult for businesses to plan and invest for the future, which can lead to a decrease in overall economic activity. This, in turn, often leads to fewer available jobs and higher unemployment.

Stagflation also lowers living standards. This happens for two reasons. First, higher prices cut in to consumers' purchasing power. Second, stagflation results in lower wages as businesses attempt to cut costs, which further reduces the standard of living for workers and their families.

Finally, stagflation can lead to social unrest. People become disgruntled when their standard of living is in decline. And the longer that a stagflationary period drags on, the more likely that citizens may begin to call upon their elected officials to take steps to intervene.

Inflation vs. stagflation

There are several key differences between inflation and stagflation. While stagflation can’t happen without rising inflation, you can have inflation without stagflation.

Inflation is when the price of goods and services increases, meaning your money is worth less. If inflation is at 8%, something that costs $100 will cost $108 next year. Inflation generally occurs during a period of economic growth.

In fact, the Federal Reserve considers 2% inflation growth the ideal amount, along with maximum employment. Inflation can keep deflation at bay. However, when inflation rises too much, it can overheat the economy and lead to a recession.

Stagflation, on the other hand, occurs when the economy experiences slowing growth along with high inflation.

More: The fed is pulling out all the stops to fight inflation

Are we experiencing stagflation?

The simple answer is no. While inflation is very high (up to 8.6% in May), the labor market remains very strong. The U.S. unemployment rate has returned to pre-pandemic levels and seems steady. But many economists besides the World Bank have warned that there are signs that we could see another period of stagflation.

Former Federal Reserve Chairman Ben Bernanke voiced concerns about a slowing economy and continuing supply chain issues and criticized the Fed for not acting fast enough.

Meanwhile, Treasury Secretary Janet Yellen is keeping an eye on global inflation. “The economic outlook globally is challenging and uncertain, and higher food and energy prices have stagflationary effects, namely, depressing output and spending and raising inflation all around the world,” she said at a G7 Finance Ministers and Central Bank Governors meeting in May 2022.

What the fed and government can do to avoid stagflation

There are a few things that the Fed and government can do to avoid stagflation.

First, they can try to reduce the inflation rate by increasing interest rates, which the Federal Reserve has been aggressively doing throughout 2022. This helps combat inflation by slowing down how much people spend. However, that could also impact economic growth, which is one reason the Fed waited so long to raise rates.

President Joe Biden could also roll back some of the tariffs imposed by the Trump administration, which would lower consumer costs. Although some experts say that this wouldn't have a large impact. Biden could also try to increase economic growth by providing a stimulus package. But this would likely only increase inflation more.

What investors can do to hedge against stagflation

Stagflation isn’t good for the economy or investors' portfolios. In a February report, Morgan Stanley stated that the U.S. economy is overheating and is likely to enter stagflation at the end of the year. While equities and other assets don’t do as well during stagflation, *“historically commodities have been the best performing asset class during stagflation,” the report said.

The investment bank has also recommended a barbell strategy. This is when investors are overweight in their portfolios in both high-risk and low-risk stocks to hedge against uncertainty about the stock market's next move. This is an attempt to balance risk and reward.

Meanwhile, analysts at Jefferies point out that stocks with high dividends also tend to outperform the market during periods of stagflation.

Whether or not these strategies will work for you depend on your personal circumstances, so make sure to do your research and talk to a financial advisor.

The bottom line

With rising inflation, surging oil prices, and concerns about economic growth, it’s no wonder that economists are worried about stagflation. If the Fed can lower inflation without hurting economic growth, it’s likely we won’t experience stagflation.

Unfortunately, there's no way to predict the future. Only time will tell if inflation continues to heat up as the labor market cools. For investors concerned about their portfolios, it’s wise to talk to your financial advisor to figure out a strategy to hedge against stagflation risk.

Further reading:

• Is Bitcoin a good inflation hedge? (study)
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