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Stagflation combines the words “stagnant” and “inflation.” It describes a period of low to nonexistent economic growth coupled with rapidly rising prices.
This has happened only once before in the United States, back in the 1970s.
Key Takeaways
- Stagflation is a stagnant economy combined with high inflation.
- This type of economic crisis is often caused by big supply shocks and easy monetary policy. They last longer than regular recessions because there’s no definitive cure.
- Interest rates are normally cut to stimulate economic activity when a recession strikes but
central banks can’t easily do that when inflation is soaring. - Some economists fear that the U.S. economy is heading for stagflation for the first time since the 1970s.
The Difference Between Stagflation and Recession
A recession is generally said to be in motion when there have been two consecutive quarters of negative economic growth. Stagflation is much more open to interpretation.
A stagnant economy isn’t necessarily one that’s in a recession. The term “stagnant” implies sluggishness and a lack of activity that could mean either a full-blown downturn or just very weak growth. The level of inflation isn’t defined either, but we can assume that it has to be at least above the 2% threshold set by most central banks in advanced economies.
Two more key differences are time and frequency. Recessions are considered a normal part of the economic cycle. They happen quite often and historically last just less than a year. Stagflation is uncommon and tends to stick around. These types of economic crises are difficult to defeat because the traditional move of lowering borrowing rates to stimulate growth is taken off the table.
High inflation is normally associated with economic growth. It can be culled by hiking interest rates. Stagflation is harder to tame.
What Causes Stagflation?
It’s generally agreed that the main cause of stagflation is a major supply shock. Things tend to get off-kilter when the supply of food, oil, or something else that’s essential is disrupted and is no longer able to meet demand. The situation is often made worse by poor economic policies.
Supply shocks lead prices to rise, hurting businesses, consumer finances, and economic growth. Central banks respond as they normally do to economic turmoil by making sure money is cheap to borrow so they essentially feed the flames of inflation, stimulating demand and pushing prices up further.
The term “stagflation” was first used in 1965 by British politician Iain Macleod.
History of Stagflation
The U.S. has only experienced a serious case of stagflation once in the 1970s when the supply of oil decreased drastically and prices consequently rocketed. This occurred first because of an embargo stemming from a war between Israel and the Arab states and later as a result of the Islamic revolution in Iran.
These events caused inflation to spiral out of control and threw the economy into disarray, along with easy monetary policy that the American central bank, the Federal Reserve, pursued to lift employment. Very high interest rates and a difficult recession were necessary to restore order. The stock market got crushed.
Central banks ease monetary conditions when the economy is heading toward recession. They can’t do that when inflation is high, however, and that’s potentially worrying.
Why Is Stagflation Bad for the Economy?
Stagflation is a combination of three negatives: slow economic growth, higher-than-normal unemployment, and expensive costs of living.
Interest rates are typically cut to get companies hiring again and the economy back up and running, but that action can be dangerous when inflation is soaring. We’re left with people and companies strapped for cash at a time when higher prices to service their debts and obligatory purchases cost more and more each week or month.
This isn’t just an extremely uncomfortable environment to live in— it’s also quite tricky for governments to fix. Stagflation can drag on for years with no easy cure, causing heavy damage to the economy.
Is Stagflation Worse Than a Recession?
Yes. Stagflation is basically like a recession with the added headache of rising prices and costs to service debt. There’s no definitive cure, so it’s harder to defeat. It can last a long time.
Is It a Good Idea to Buy a House During Stagflation?
It could make sense to buy now rather than wait if prices continue to rise, but lackluster economic growth might also weigh on house prices while the high interest rates necessary to combat inflation will mean less favorable borrowing terms. A lot depends on individual circumstances, what rate you’re offered, and how long peak inflation persists.
What Investments Perform Best During Stagflation?
Not many traditional asset classes fare well in this kind of environment. The best performers would probably be those with inflation-hedging characteristics such as inflation-indexed bonds, gold, and possibly real estate.
The Bottom Line
Many of us have experienced what living in a stagnant economy is like but will be unfamiliar with stagflation. Judging by its criteria—an economic slowdown where people are losing their jobs while bills keep on rising—and accounts from the 1970s, it’s clear that everyone would be better off if it remained history. Stagnant growth and high inflation can do great damage to an economy and leave scars for years to come.
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