What Is Stagflation? Inflation Vs. Stagflation

What Is Stagflation? Inflation Vs. Stagflation

Stagflation refers to a state of economic conditions characterized by significant inflation, high unemployment, and slow or no economic growth. The term itself is a combination of “stagnation” and “inflation”. Prior to the 1970s, dominant economic theories posited that inflation would increase when unemployment rates were low and decrease when they were high. This theory was based on the Phillips Curve, an economic model that proposed an inverse relationship between unemployment and inflation. However, the prevalence of stagflation in the 1970s and 1980s surprised economists and forced them to refine their theories. Today, economists recognize that stagflation can be caused by a variety of factors, including sudden supply shocks and harmful government policies.

Stagflation in 2022

In 2022, certain economists expressed concern about the possibility of stagflation in the U.S., due to a sharp rebound in consumer demand in the previous year, coupled with significant supply chain issues that have driven up prices. Additionally, Russia’s invasion of Ukraine led to a surge in fuel prices, which occurred alongside the Federal Reserve’s rate hike campaign. If stagflation persists, it can have a serious impact on the economy, including potential decreases in GDP that could ultimately result in a recession.

Consequence of Economic Stagflation

Stagflation has a direct impact on regular people, making it harder for many to meet basic needs, particularly those who are unemployed. For those who are employed, it can lead to job losses and lower wages, which decreases consumer confidence and purchasing power.

Investors are also negatively impacted by stagflation, as it can result in lower profit margins due to higher input prices and lower sales. This has an impact on the stock market, as the S&P 500 has historically returned -2.1% during times of stagflation, according to a Goldman Sachs report. Stagflation can directly impact investors by decreasing companies’ earnings per share, which can impact stock prices. Dividend investors may also be negatively affected as companies reduce or suspend their dividends to conserve cash, while growth stock investors may experience significant losses if growth targets are not met.

If stagflation persists, some companies may go bankrupt, causing significant investor losses. The inability of companies to repay their debts would also likely affect bond prices. However, there are ways that investors can hedge the risk of inflation, including funds that are designed to navigate high inflation periods. Investors worried about the impact of stagflation on their portfolios might want to shift their investment strategy or consider blue chip stocks in staple industries with steady earnings that are likely to weather stagflation or recover quickly.

Stagflation could impact international trade by increasing global commodity prices, including food, making it more expensive to do business and increasing inflation further. National or global unemployment can also reduce global economic output, consumer confidence, and spending, increasing unemployment in more areas because of the interconnectedness of global trade.

Different national policies for tackling stagflation might also impact global trade, creating different conditions for recovery that may conflict. This often affects emerging and developing economies more, as many of these countries lack the capacity to institute the kind of monetary or stimulus policies other nations use to tackle stagflation due to their high deficit-to-GDP ratios.

1970s Stagflation Example

The 1970s oil crisis is often cited as a prominent example of stagflation. The crisis was triggered when the Organization of the Petroleum Exporting Countries (OPEC) declared an oil shipping embargo in October 1973, in response to Western support of Israel during the Yom Kippur War. The embargo caused oil prices to surge immediately, rising by over 300%. This resulted in major issues in the United States, which heavily relied on cars, and despite the embargo ending in March 1974, oil prices remained high. This period coincided with a shift of manufacturing jobs outside the U.S., the Vietnam War, and rising labor costs, which led to a prolonged period of stagflation characterized by rapid inflation, high unemployment, and a stagnant economy.

The transition of the U.S. economy from manufacturing to lower-paying service jobs caused real wages to stall, consumer confidence to decline, and spending to decrease, thereby exacerbating the crisis. President Richard Nixon attempted to address stagflation by devaluing the dollar and implementing price and wage freezes, but this strategy failed and is now regarded as one of the major macroeconomic policy failures in American history by economists such as Jeremy Siegel. The prevalent belief at the time was that high inflation led to low unemployment, but during the 1970s, both inflation and unemployment increased. A reorientation of economic policy that focused on low unemployment and price stability was required to halt stagflation. Many economists today attribute the stagflation crisis of the 1970s to the Federal Reserve’s growth of the money supply.

What Causes Stagflation?

Economists debate the causes of stagflation, as economic theory before the 1970s, when stagflation occurred, supported the inverse relationship between unemployment and inflation suggested by the Phillips Curve. However, several theories have been proposed for the causes of stagflation:

  1. Supply shock theory explains that stagflation results from a sudden decrease in the supply of a service or commodity that causes prices to rise, reducing profit margins for most companies and slowing economic growth.
  2. Bad monetary policies theory suggests that stagflation is often caused by poor economic policies of central banks and governments, which can lead to wrong choices such as the focus on maximum employment across the economy in the U.S. after the Employment Act of 1946. Government policies regulating the economy can also have an impact, as shown by the Nixon strategy of devaluing the dollar and instituting wage and price freezes known as the Nixon Shock.
  3. Differential accumulation theory created by economist Jonathan Nitzan and Shimshon Bichler posits that mergers and acquisitions, stagflation, and globalization are linked through differential accumulation that concentrates the power to limit the supply of commodities and accumulated capital in fewer hands, leading to higher risks of stagflation.
  4. Demand-pull stagflation theory proposed by economist Eduardo Loyo suggests that stagflation can occur exclusively from monetary shocks without the need for a supply-related shock.
  5. Cost-push inflation theory sees supply-side inflation as a key driver of stagflation that leads to unemployment as it reduces profit margins for companies and economic output. Supply-side inflation can also be impacted by tariffs, increases in wages, or labor shortages.
  6. End of the gold standard is theorized as one driver of 1970s stagflation due to the vulnerability of the U.S. to runs on gold as more dollars were in foreign hands than gold reserves in the U.S. Nixon’s ending of the convertibility of U.S. dollars to gold and the decoupling of the value of the U.S. dollar from gold devalued the dollar, impacting inflation and economic growth, and leading to stagflation.

Deflation vs. Disinflation vs. Hyperinflation

There are multiple “flations” in economic terminology, including inflation, deflation, disinflation, stagflation, and hyperinflation.

  • Inflation refers to the general increase in the prices of goods and services over time, reducing purchasing power, which may prompt central banks to increase interest rates to slow down the economy.
  • Deflation refers to the opposite of inflation, where prices of goods and services decrease over time, typically resulting from a reduction in the money supply or credit availability.
  • Disinflation refers to a reduction in the rate of inflation, where the inflation rate slows down but does not lead to a decrease in prices.
  • Stagflation occurs when an economy experiences stagnation accompanied by an inflationary environment, usually leading to rising costs of goods and services, higher interest rates, and increased unemployment.
  • Hyperinflation is an extreme form of inflation characterized by a rapid increase in the prices of goods and services, often resulting in excessive currency devaluation.

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