What Is Stagflation in Economics? Overview, Causes and Consequences

The Covid-19 pandemic has fueled a long list of economic aftershocks that may reverberate for years to come. One of them is the highly debated risk of stagflation, a toxic brew of economic stagnation and inflation.

What is stagflation?

Stagflation occurs when multiple negative economic forces combine: slow economic growth, a faster rate of inflation, and a high unemployment rate.

Stagflation is an economic nightmare scenario for investors, central banks like the U.S. Federal Reserve, and everyday citizens alike. Higher prices mean consumers have to pay more for goods and services, while high inflation decreases their purchasing power even further because their money is worth less.

What’s more, there are few tools for authorities like the Fed to combat stagflation, or both inflation and economic stagnation simultaneously. That’s because most of the tools aimed at lowering inflation may increase unemployment, and policies to decrease unemployment may worsen inflation.

Economists once thought stagflation was impossible, because inflation isn’t supposed to rise when the economy is weak. But in the U.S., widespread use of the term stagflation began in the 1970s, after an oil-supply crisis pushed the country into five quarters of negative gross domestic product (GDP), double-digit inflation, and an unemployment rate that peaked at 9%.

What causes stagflation?

Economists are not united on a single theory about the cause of stagflation, in part because the onset of the phenomenon in the ’70s upended the prevailing economic schools of thought at the time. Since then, experts have debated multiple potential reasons that stagflation happens.

Supply shock

One leading theory centers on supply shocks, or an unforeseen event that dramatically changes the supply, and thus price, of something. A supply shock of oil, in particular, might cause stagflation because so much of the world depends on it for energy. 

That’s what happened when the Organization of the Petroleum Exporting Countries (OPEC) enacted an oil embargo against Western nations in 1973, in retaliation for U.S. support of Israel during the Arab-Israeli war. OPEC’s embargo banned petroleum exports to the U.S. and other countries that supported Israel. With reduced worldwide supply, the price of a barrel of oil soared—quickly doubling and then quadrupling. The price spikes coincided with other economic trends at the time, including but not limited to a devalued U.S. dollar and a decline in U.S. productivity—in effect, meaning the U.S. economy was producing less with more inputs of labor and capital. 

The higher oil prices created a domino effect, increasing the costs of producing goods, leading employers to save money by cutting payrolls. The oil price spikes also increased the costs of transportation needed to get those goods onto shelves, so even as more people were out of work, prices rose. After many failed talks, OPEC finally lifted the embargo in March 1974.

Poor economic policy

Another top stagflation theory blames suboptimal economic policy as the main cause. Proponents of this theory point out that governments and central banks may overregulate markets and industry while also flooding the economy with too much money. 

To use the stagflation example in the 1970s, economists who support this theory cite the Fed’s economic policy during the boom years of the late ’50s and ’60s in a bid to keep unemployment rates low and boost demand for products and services. But unemployment was kept unnaturally low during the ’60s, triggering a phenomenon called a wage-price spiral—as workers received higher wages they increased spending on goods and services, sending prices higher.

In response, then-President Richard Nixon implemented policies in 1971 that included import tariffs and a 90-day freeze on wages and prices. Nixon, in a bid to get re-elected, hoped to boost growth without increasing inflation—so prices would stop rising and the economy could right itself. But soon, the sudden supply shock of OPEC’s oil embargo threw everything into chaos.

Monetary policy and the end of the gold standard

Still another school of thought centers on monetary policies as a key driver of stagflation. Another of Nixon’s 1971 actions was to end the U.S. dollar’s “gold standard,” which pegged the value of the U.S. dollar to the value of a specific amount of gold. The gold standard was established in 1944’s Bretton Woods Agreement and turned the dollar into a global currency. Under this pact, the Group of Ten (G-10) industrialized nations had committed to fixing the values of their currencies to the U.S. dollar. But by 1961, the amount of U.S. dollars outstanding had outstripped the U.S. government’s gold supply at Fort Knox, and in the coming years, a run on gold seemed imminent. 

Once Nixon removed the U.S. dollar from the gold standard, the price of gold soared and the value of the U.S. dollar plummeted. This sent the prices of imports up even more, on top of the tariffs Nixon had imposed. His attempts to fuel growth and stop inflation in fact had the opposite effect.

In response, the Fed tried to pull the levers it had available to stop stagflation. But its moves resulted in what would come to be called “stop-go” monetary policy with the central bank switching between combating high unemployment and rising inflation. In the “go” phases, the Fed lowered interest rates to increase the money supply and boost employment. Then during “stop” periods when inflation was rising, the Fed raised interest rates to slow growth and cap inflationary pressures.

The market was left confused. And the Fed’s stop-go policies couldn’t fix the underlying problem: Without additional dollar reserves, the whole system was unstable in the long run. Inflation and unemployment both rose in the mid-’70s, and while unemployment ticked down a bit by the end of the decade, inflation reached 11% in June 1979.

Just weeks later, Paul Volcker was named chairman of the Fed in August 1979 in large part because of his staunch anti-inflation views. In his opinion, the central bank’s main responsibility should be combating inflation. It took time, but under his leadership the Fed aggressively and consistently tackled the money supply rather than interest rates. Even though the economy entered a recession in the third quarter of 1981, it eventually recovered to a healthy level. By October 1982, inflation fell to 5% and long-term interest rates began to decrease as well.

Is there a cure for stagflation? 

Just as there is no consensus on the cause of stagflation, there is no single answer for a “cure” when the ugly and rare phenomenon happens. For all of the current debate about stagflation, some experts say it’s unlikely to occur again; just as the coronavirus pandemic was a once-in-a-century occurrence, an extreme oil supply shock or the ending of the gold standard was a one-time event. Furthermore, the Fed now is more consistent with its interest rate changes, signals them in advance and doesn’t engage in stop-go tactics.

The bottom line

While some believe full-blown stagflation will not happen again, generally economists agree that when the trends are leaning that way, the key is to be aggressive in combating it. That means an economy ought to increase productivity enough so that it spurs higher growth without higher inflation, and in turn, the Fed should tighten monetary policy to rein in inflation.