What is stagflation?

Stagflation is when slow economic growth is accompanied by high unemployment and soaring inflation. It’s a rare economic malady, but a particular potent one and requires an extra big dose of hard medicine for convalescence.

What is stagflation?

The term stagflation is a portmanteau, coined by British politician Iain Macleod in the 1960s, which combines stagnation and inflation.  It is a nasty state of affairs that is difficult for any country to eradicate.

Theoretically when prices rise, and the economy is booming, unemployment should be low. That’s why economists considered stagflation to be a boogeyman, an imaginary worse-case scenario.

After all, businesses are motivated to hire more people, or increase wages to retain employees, so that they can create the goods and services to match the demands of the market.

When prices rise too quickly, such as higher than the Federal Reserve’s 2% target, for too long, action is required. Typically, that manifested in the form of the Fed raising interest rates, thereby weakening demand for goods and services, thereby lessening the need for workers, thereby causing higher unemployment rates. (This relationship between higher inflation and lower unemployment is called the Phillips Curve.)

But when it comes to stagflation, the usual rules don’t apply. Instead, persistently high inflation is coupled with rising unemployment – the worst of both worlds.

In recent history, the U.S. dealt with stagflation during the 1970s. It was difficult for the economy to recover, and millions endured economic hardships as the Fed eradicated the illness through a prolonged period of very high interest rates.

What causes stagflation?

Economies are complex systems, meaning experts debate the causes and effects of every phenomenon. However, supply chain shocks, followed by poor economic decisions from policymakers, helped bring about stagflation more than 40 years ago.

The causes of stagflation in the 1970s

A shock to the supply chain is when there’s a sudden change in the availability of key goods and services.

This occurred in the early 1970s after the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an embargo on U.S. oil imports following President Richard Nixon’s aid to Israel during the Yom Kippur War.

While the embargo was lifted less than six months later, the price of oil had quadrupled and remained high since the U.S., as well as other non-OAPEC members, were not able to increase oil production.

Along with a series of other economic events, from the unwinding of the Vietnam war to global growth and crop failures to the decline value of the U.S. dollar, prices soared across the economy. Inflation, as measured by the Consumer Price Index, rose by more than 4% each year from 1973 to 1982, part of a period known as the Great Inflation.

Despite the best intentions, national economic policies can have poor effects and contribute to stagflation.

For example, when gas prices started to spike in the early 1970s, the Nixon administration implemented temporary wage and price controls, but inflation continued to rise and stagflation took hold anyway, leading one economist to call the American economy a “limping giant.”

Only by the Fed raising interest rates from more than 6.00% in early 1973 to more than 20% by the early 1980s was inflation ultimately brought back under control.

Stagflation vs inflation

Inflation reflects rising costs of goods and services, and is a necessary part of economic life. After all, you don’t want prices overall to fall, since that would result in a lower standard of living.

Therefore, the Federal Reserve targets an average annual inflation of 2% to support economic growth, maximum employment and price stability. Think of it as a goldilocks zone.

Recently, however, the U.S. economy, and many economies around the world, have seen inflation soar well above that target level. Prices rose by 4.70% in 2021, and then by 8.00% in 2022. The Fed responded by hiking rates by more than five percentage points and shrinking its balance sheet.

However, this era of high inflation was not accompanied by high unemployment or weak economic growth. Both measures have remained strong, thereby lessening the damage to the American household.

Stagflation vs recession

Recessions are characterized by a significant decline in economic activity that lasts more than a few months.

“The most common and simple way to measure this is by looking at GDP growth rates from quarter to quarter and declaring a recession when the number is negative twice in a row,” said Dr. Nicholas B. Creel, assistant professor of business law at Georgia College and State University.

However, that is not a hard-and-fast rule. Rather, the National Bureau of Economic Research has some wiggle room in identifying when a recession occurs, taking into account such factors as consumer behavior and the employment picture.

The NBER has identified more than a dozen recessions since 1945, with the most recent one being in early 2020, at the onset of the pandemic.

During a recession, inflation and employment tend to fall.

“People are more willing to accept lower pay for their labor,” said Creel.

A lower-paying job may be better than no job when things are tough. And, as you’re earning less, you’re not willing to freely spend money, which drives down prices, lowering inflation.

A recession is distinguished from stagnation, then, by moderating inflation.

The dual pressure of inflation and unemployment “causes much more widespread misery,” said Creel. “More people find themselves out of work while also experiencing an increase in the cost of living. Even the employed tend to be much worse off in this scenario as […] their buying power goes down and they can’t expect a raise to make up for it.” 

How to beat stagflation 

At a national level, stagflation presents a difficult situation for policymakers. Generally, leaders must choose between taming inflation and boosting economic growth.

The government may step in to alleviate supply shocks, but, on an individual level, stagflation can make managing your household finances challenging.

Build financial flexibility

Financial flexibility is a key element of weathering any economic storm, including stagflation. Some of the best ways to boost your financial flexibility include building an emergency fund, paying down debt and growing additional income streams.

If you have more flexibility in your finances, an unexpected spike in living expenses or a job loss should be less devastating. Ideally it will provide the breathing room you need to get back on track with minimal stress.

Be strategic with job decisions

A secure job is a key element of minimizing financial pain during stagflation.

“If you do expect stagflation, you might [be] better off taking a more secure job than you would a higher paying one,” said Creel.

Job security should be a factor in your employment decision, along with job pay.

Delay certain purchases

During tough economic times, it’s important to take a closer look at your spending. It could be wise to funnel more of your income into savings and delay purchases of items that have been highly affected by inflation.

For example, if you waited until this year to purchase a used car instead of getting one in 2022, you would likely have saved some money —  the average used car price fell 6.4% year over year; the market has started to recover from supply chain issues caused by the pandemic.