What Is Stagflation?

What Is Stagflation?

Stagflation is a combination of high inflation, high unemployment, and stagnant economic growth. Because inflation isn’t supposed to occur in a weak economy, stagflation is an unnatural situation. 

Slow growth prevents inflation in a normal market economy. Then, consumer demand falls enough to prevent prices from rising. Stagflation only occurs when government policies disrupt the functioning of the normal market.

Key Takeaways

  • Inflation plus unemployment and stagnant growth equals stagflation
  • Stagflation results in a recession or slow economic growth, as well as rising prices and unemployment
  • Conflicting expansionary and contractionary fiscal policies cause stagflation

Causes of Stagflation

When the government or central banks expand the money supply while constraining supply, stagflation occurs. The most common culprit of stagflation is the government printing currency, but it can also take place when a central bank creates credit with its monetary policies. Both of these situations create inflation and increase the money supply.

Meanwhile, other policies slow growth at the same time. This happens when the government raises taxes, and it can also occur when the central bank increases rates of interest. In both cases, companies are prevented from producing more. In situations where conflicting expansionary and contractionary policies take place, growth can slow while inflation is created (i.e., stagflation). 

When comparing United States gross domestic product (GDP) by year to inflation by year, you can see that stagflation took place in the U.S. in the 1970s. At this time, the federal government manipulated currency to propel economic growth. Meanwhile, it used wage-price controls to restrict supply. Another example is Zimbabwe in 2008, when the government printed so much money that it actually moved beyond stagflation into hyperinflation.

Stagflation in the 1970s

During the 1973-1975 recession, stagflation got its name. Gross domestic product was negative for five quarters. Two months after the recession ended in May 1975, unemployment peaked at 9%. In 1973, inflation tripled, from 3.6% in January to 8.7% in December. Inflation increased to a range between 10% and 12% from February 1974 to April 1975. 

The 1973 oil embargo is often blamed for stagflation in the 1970s. When OPEC reduced its oil exports to the U.S, prices quadrupled, and inflation in oil was triggered.

But this alone wasn’t enough to be the sole cause of stagflation. In reality, the cause was a combination of monetary and fiscal policy. It all began with a mild recession in 1970, when GDP was negative for two quarters, and unemployment increased to 6.1%. At this time, President Richard Nixon was running for re-election, and his goal was to boost growth while avoiding triggering inflation.

Nixon announced three fiscal policies on August 15, 1971, and these policies got him re-elected–but they also sowed the seeds for stagflation. The announcement of huge economic policy changes became known as the Nixon Shock.

The Nixon Shock

Three actions taken by Nixon constitute the Nixon Shock.

  1. Nixon instituted a 90-day freeze on all prices and wages. He established a Pay Board and Price Commission to approve any increases after the 90-day freeze. This commission would control prices until after the 1972 presidential campaign, which was Nixon’s plan to control inflation.
  2. Nixon imposed a 10% tariff on imports with the goal of lowering the trade deficit while protecting domestic industries. This resulted in the import prices rising as a result of the tariffs.
  3. Nixon withdrew the U.S. from the gold standard, which had kept the dollar’s value tied to a fixed amount of gold ever since the Bretton Woods Agreement in 1944.

Under the Bretton Woods Agreement, the majority of countries agreed to attach their currencies’ values to either the U.S. dollar or the price of gold, which turned the dollar into a global currency. 

When the United Kingdom attempted to redeem $3 billion for gold, a crisis occurred because the United States didn’t have that amount of gold in its Fort Knox reserves. At this point, Nixon stopped redeeming dollars for gold, which led to skyrocketing gold prices and the plummeting value of the dollar. This resulted in increased import prices.

The second two parts of the Nixon Shock slowed economic growth by raising import prices. Since United States companies weren’t able to raise prices to remain profitable, growth slowed even more. Then, since U.S. companies couldn’t lower wages, they were forced to lay off workers in order to reduce costs, increasing unemployment. Unemployment, in turn, slows economic growth and reduces consumer demand. Clearly, Nixon’s three policies, aimed to boost growth and control inflation, had the opposite of the intended effect. 

Stop-Go Monetary Policy

The Federal Reserve took action to fight stagflation, but its attempts only worsened the situation. Between the years 1971 and 1978, the Federal Reserve tried to fight inflation by raising the fed funds rate. Then it lowered the fed funds rate in an attempt to fight the recession. This “stop-go” monetary policy was confusing for businesses; they chose to keep their prices high, even when the Federal Reserve lowered rates. This then increased inflation to 13.3% by the year 1979.

In 1980, Federal Reserve Chair Paul Volcker was able to end stagflation by increasing the fed funds rate to 20%. But the end of stagflation came at a high cost, as it resulted in the 1980-1982 recession.

Why Stagflation (Probably) Won’t Reoccur

People began to feel concerned about stagflation once again in 2011, worrying that the Federal Reserve’s expansive monetary policies, which were put into place to improve the economy after the financial crisis of 2008, would cause inflation. Congress approved a far-reaching fiscal policy at the same time; this included record levels of deficit spending, as well as the economic stimulus package. At this time, the economy was only growing by 1% to 2%, and people began to worry about the risk of stagflation if the economy didn’t improve while inflation got worse. 

Deflation was prevented by this huge increase in global liquidity, and this was a much greater risk. The Federal Reserve doesn’t allow inflation to increase beyond its target of 2% as the core inflation rate. Therefore, if inflation advanced beyond that target, the Federal Reserve would then reverse course by instituting a constrictive monetary policy. 

The unusual combination of conditions that led to stagflation in the 1970s is not likely to occur again. This is because the Federal Reserve doesn’t practice stop-go monetary policies anymore, but instead commits to a consistent direction. In addition, the withdrawal of the U.S. dollar from the gold standard is an event that can only take place once. Finally, the wage-price controls that constrained supply back in the 1970s would never be considered in today’s day and age.