This economic condition is a perfect storm of negative events
Stagflation is a combination of high unemployment combined with slow (or stagnant) economic growth. The slow economic growth is defined as a period of negative growth in a country’s gross domestic product (GDP). What makes stagflation such a thorny problem is that for stagflation to exist inflation also has to be rising.
This creates a condition where demand for goods and services weakens which in turn makes it difficult for businesses to hire workers. And that’s why stagflation is usually the precursor to a recession.
In this article, we'll look at the relationship between inflation and stagflation and why you can't have one without the other. We'll also visit the history of this term and also how it affects your personal finances including your investments.
An Apparent Contradiction
Stagflation is an improbable, but not impossible occurrence. That’s because two of the conditions that are required to measure stagflation (i.e. unemployment and inflation) tend to move in opposite directions. That is at times of high unemployment, prices usually go down and vice versa.
For a long time, traditional economic theory dictated that macroeconomic policy was a trade-off between unemployment and inflation. But after the Great Depression, economists put more emphasis on the dangers caused by deflation. Their argument was that policies meant to lower inflation made it tougher for the unemployed to find work. Therefore inflation was allowed to become a permanent part of the economy as a “necessary evil.”
So What Is Inflation?
So to help reconcile this contradiction, it’s important to first understand what inflation is. Inflation is when there is an erosion of a currency’s purchasing power. Simply put, it’s those times when you notice that a dollar buys less than it did a short time before.
According to traditional economic theory, inflation occurs when the money supply grows at a pace that exceeds that of economic growth. This can be understood using the concept of supply and demand. When there is a greater supply of money, the demand to buy goods and services can quickly exceed the ability of the private sector to bring goods and services to market. That creates a supply shortage. And that causes the price of the remaining goods and services to move higher. That’s inflation.
When Does Inflation Become “Too Much”
As I wrote earlier, modern economic theory accepts a little bit of inflation as being “normal.” In fact, the United States Federal Reserve has set a target inflation rate of 2%. But when inflation exceeds this target rate, the central bank will take measures to reduce the money supply. This is typically done by raising interest rates (the Federal funds rate). When this occurs, consumers feel it in the interest rates they pay when taking out personal loans, mortgages, and credit cards. Higher interest rates also make it more expensive for businesses to borrow to meet their capital needs.
Origin of Stagflation
If stagflation sounds like a made-up word, that’s because it is. Or maybe a better way to say it is that it’s a combination of the words inflation and stagnation. The word was introduced by a British politician named Ian Macleod in the 1960s.
However, it wasn’t until the 1970s that the term got widespread use in the United States. This was a time marked by four separate years of negative GDP growth with two of those years coming back to back. Inflation increased from 3.6% in 1973 to over 8.3% in 1974. Unemployment in 1973 was 4.95% but jumped to 8.5% in 1975. Not surprisingly, there were two recessions during this time.
What Creates Stagflation?
Stagflation occurs when there are rising prices and low output. Previous stagflation periods have started with rising energy costs (i.e. oil, gas, and electricity) that cause companies to pay more to manufacture products and to move them to stores.
However, higher energy prices by themselves are not the sole reason for stagflation. Instead, it’s usually combined with government policies that regulate labor, markets, imports, and production. This results in fewer products entering the market.
And the combination of rising prices and fewer goods to be bought leads to lower consumer demand. This starts a spiral where businesses begin to lay off workers which leads to a continued weakening of demand.
How Does Stagflation Impact Personal Finance and Investments?
Investors are also consumers. So if your paycheck increases by 5% but inflation is running at 8%, your real earnings are lower.
Inflation also directly reduces the total return of your investments. If your investments are up 5% for the year, but inflation is running at 8%, your actual investment is worth -3%. The same is true of bonds. If a bond pays 3%, but inflation is running at 6% that bondholder is losing money on their investments.
Also, on a broader level, stagflation creates uncertainty in the economy. One reason for that is that consumers become more concerned about losing their job. This means that they pull back on their personal spending in an effort to increase their savings. When you consider that consumer spending is the engine that drives the economy, it’s not hard to see why less consumer spending will make it hard to reverse poor economic growth.
How to Cure Stagflation?
It’s not particularly easy. Modern economic theory tends to focus on bringing inflation down. The theory is lower prices will stimulate demand which will increase employment and economic growth. And bringing down inflation typically means raising interest rates.
For example, to get out of the stagflation that bedeviled the nation in the 1970s, the United States took a course of raising interest rates quickly and steeply. This did bring on a sharp recession, but it was ultimately successful in bringing inflation down. However, another component of that period was the fact that the government also lowered taxes at that time.
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