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What is stagflation?

stagflation definition

Stagflation is a period characterised by high inflation and weak economic growth.  

The term ‘stagflation’ has made a comeback in recent times as economies across the globe see a surge in inflation and the start of global monetary tightening cycle after years of ultra-low interest rates, raising concerns of economic growth slowdown.

In this article, we look at what stagflation means and how stagflation occurs.

The term ’stagflation’ was first used in the 1960s by British politician Iain Macleod. He spoke of a period of “stagflation”, having seen the cost of living rise and industrial production and earnings fall.

“We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of ‘stagflation’ situation and history in modern terms is indeed being made,” said Macleod.

Why is stagflation bad? “Few scenarios alarm economists and investors as much as stagflation — a toxic combination of economic stagnation and inflation,” said the Switzerland-based UBS Chief Investment Office in a report.

The misery index, which measures the sum of the unemployment rate and inflation rate, was popularised after the stagflationary period of the 1970s. 

What is the cause of stagflation? 

The history of stagflation shows that the sudden increase in oil prices has been a key driver in stagflation scenarios. 

It happened in 1973 when Arab members of the Organisation of Petroleum Exporting Countries (OPEC) imposed an oil export embargo on the US and various European nations for supporting Israel in the Arab-Israeli War. Oil prices skyrocketed, resulting in increased overall costs and rising unemployment. 

The jump in fuel prices alone was not the sole cause of stagflation in the 1970s. Poor economic policies like import tariffs and wage freezes in the US may have played a role in stagflation.

The 1970s also saw one of the most dramatic shifts in monetary policy when President Richard Nixon's administration decided to end dollar convertibility to gold.

Historical data shows that the Dow Jones Industrial Average (US30) Index ended the 1970s close to flat. The index opened at about 809 points in January 1970 and closed at about 838 points in December 1979.

According to The World Bank, the current economic condition seen in 2022 resembles the 1970s’ stagflation example in three key aspects:

  • Inflation fuelled by persistent supply-side disturbances

  • Preceding period of highly accommodative monetary policy 

  • Vulnerabilities economies face with respect to monetary policy tightening needed to stem inflation  

“Stagflation also represents a painful dilemma for central bankers: If policy is tightened to combat inflation, unemployment is likely to be exacerbated. This leaves policymakers with no easy options. Paul Volcker, then the Federal Reserve chair, raised the federal funds rate as high as 20% in June 1981—at the cost of rising unemployment for several years—in order to finally bring inflation down,” said UBS CIO in a report.

The World Bank noted that ongoing stagflation concerns differ from the 1970s as the dollar is comparatively stronger, percentage increases in commodity prices are smaller and the balance sheets of major financial institutions are better.

Stagflation vs inflation

According to the US Federal Reserve, inflation is the rise of the price of goods and services over time. Inflation erodes the value of money over time.

Unlike stagflation, inflation is not always bad. A low, stable and predictable level of inflation in an economy is considered healthy as inflation spurs consumption. Predictable inflation gives consumers an incentive to make purchases sooner thereby boosting economic activity.

However, long-lasting periods of high inflation diminishes the value of a currency and increases costs for consumers and companies. There have been instances of hyperinflation in countries like Zimbabwe and Venezuela.

“Erosion of real income is the single biggest cost of inflation,” said the International Monetary Fund.

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