Stagflation

What is Stagflation?

Stagflation is a situation when inflation is high but economic growth is slow. Unemployment is also very high during this time.

This makes it particularly tricky for policymakers, as steps to bring inflation under control may reduce economic growth further or worsen unemployment.

The word stagflation is a combination of stagnation and inflation. A number of economists thought stagflation was impossible in the past.

Stagflation has become increasingly more common in recent decades, notably within the realm of the developed world. This can be ascribed to the saturation of their economies and the recurring challenge of high inflation in many cases.

Causes of Stagflation

Below are two broad situations that mainly cause stagflation.

Supply Shocks

Supply shocks often come in the form of rising oil, food, or similar essential commodity prices, which affect most businesses. This can make producing these commodities much more expensive.

As a result, producers pass on costs to wholesalers, retailers, distributors, and eventually final consumers, thus causing inflation. The 1970s oil crisis saw this happen and, to a lesser degree, the ongoing Russia-Ukraine war.

In some cases, like war, pandemics, or other conflicts, transport and supply chain costs can also increase dramatically. This can be because a country faces a number of embargoes and other sanctions, or parts of the supply chain are crippled by the conflict.

This, in turn, leads to manufacturers having to come up with more roundabout transport routes, thus causing these price increases.

As the manufacturing process becomes more expensive, this also causes layoffs and a decrease in output. This leads to slowing economic growth and higher unemployment, combined with the already present inflation – or in other words, stagflation.

Economic Policies

Stagflation can also occur during times of poor or volatile economic policies. This may involve more stringent taxation policies for businesses or a sudden increase in the minimum wage.

Both of these can take a toll on company profits and cause producers to pass on the costs, causing inflation. These may also lead to layoffs and higher unemployment.

Looser monetary policies, such as increased government spending or money supply, can cause excess demand in the market. This, in turn, can fuel inflation. Stricter regulations of goods and markets, such as import or export tariffs, can also contribute to stagflation.

Risks of Stagflation

The reason countries are so wary about stagflation is that it can be very difficult and take a long time to manage.

The main risks are reduced economic activity and purchasing power for consumers. This results in citizens facing both higher consumer prices as well as stagnant or diminishing savings.

Stagflation also takes a hit on economic sentiment, as soaring prices and higher unemployment embed themselves deeper into the economy.

In fact, one of the indexes used to measure stagflation is known as the “misery index”, coined by economist Arthur Okun.  This is especially true if supply shocks cause the stagflation in question.

In this case, workers may demand higher wages in order to be able to afford higher consumer prices. However, because of slower economic growth, manufacturers reduce output, which in turn makes higher wages or more hiring unfeasible.

Instead, due to the higher cost of labour demanded, there may be more layoffs. This leads to a vicious cycle that can take a long time to overcome for the economy.

Stock and bond market volatility can also be a risk of stagflation. We saw this when a degree of stagflation occurred in the aftermath of the Global Financial Crisis in 2008.

This is usually fuelled by investors being more concerned about the health of the economy. There could be mass sell-offs of shares as investors worry about company performance. Less disposable income also causes a slump in investments.

Example of Stagflation

The most notable example of stagflation is from the 1970s, caused mainly due to the oil crisis at the time. This was due to the Organisation of Arab Petroleum Exporting Countries (OAPEC) putting an oil embargo on countries that had sided with Israel during the Yom Kippur War.

This included the Netherlands, Canada, the US, the UK, South Africa, and Portugal, amongst others. The price of oil shot up almost 300% between October 1973 and March 1974, which was the first oil shock.

As oil prices rose, so did production and transport costs, resulting in consumer prices soaring as well. However, as businesses struggled to keep up with this sudden change and had to reduce outputs or even fold completely, unemployment rose as well.

The stage was set for stagflation. This sparked a number of unforeseen geopolitical and macroeconomic consequences and led to the second oil shock in 1979.

How to Manage Stagflation

There is a lot of debate about the best ways to manage stagflation. Usually, none of the available options to handle this situation are particularly desirable.

There will always be an opportunity cost in the short term. This is because a solution may target inflation or economic growth first but worsen the other factors for a little while.

In general, governments prefer to tackle inflation first before addressing unemployment and economic growth. This is because if high inflation is not tackled on time, it can quickly run rampant and cause more chaos and uncertainty in the economy.

However, balance is everything when managing stagflation. Central banks can raise interest rates for a while to bring inflation under control but must make sure not to do it for too long. Otherwise, the economy can be pushed into a deeper recession, making it harder to stimulate growth again.

Once inflation stabilizes somewhat, the government can then try to improve economic activity by reducing taxes on corporations or providing other stimulus measures. This, in turn, can also lead to more hiring and reduce unemployment.

In other cases, governments may try to address the supply shocks directly if it is within their means. Companies can also try to do the same to reduce the impact of stagflation on their businesses.

This includes:

• Improving operational efficiency
• Building sturdier supply chains
• Cost management
• Considering a variety of transport and logistics options

In some cases, stagflation may also resolve on its own once the supply side or other factors cause it to lessen or the market readjusts itself accordingly.

Are We Currently Seeing Stagflation?

Currently, a number of developed countries, such as the US, the UK, and Australia, have been seeing higher inflation for several months now.

In the UK’s case, inflation touched 11% in October 2022 but has come down to about 6.7% in October 2023. However, economic growth is still very sluggish, with the UK lagging behind several of its G-7 counterparts on this.

Energy, food, and housing costs are also high, but unemployment is quite low and rising fairly slowly. The UK economy, although sluggish, is also not in a recession currently. Similar conditions persist in the US as well.

However, both the Bank of England and the US Federal Reserve have highlighted warning signals that a recession could potentially be looming. This is due to inflation taking longer than expected to come under control.

As a result, central banks have had to almost continuously hike interest rates for months now. This has taken the global economy very close to a recession.

Thus, we are not experiencing stagflation at the moment. However, this may change if slow economic growth persists and unemployment increases.