Too embarrassed to ask: what is stagflation?

Traditionally, economists and central bankers worry about inflation or recession. But there is one thing worse than both: stagflation. Here's what it is

Traditionally, economists and central bankers worry about economies either overheating or falling into recession. If the economy is growing faster than its productive capacity allows, inflation will be the result. In this case, central banks will raise interest rates to make borrowing more expensive and thus slow the economy down. 

If the economy is growing more slowly than its productive capacity allows, recession will be the result. In this case, central banks will cut interest rates to encourage more lending and spending, pushing the economy out of recession. 

That’s the theory, anyway. However, there’s another more unusual combination which gives us the worst of all worlds. Stagflation occurs when economic growth is weak and unemployment is high, but inflation is also high. 

The term is a combination of the words “stagnation” and “inflation”. It was coined in the 1960s by British politician Iain Macleod and became popular during the 1970s when stagflationary conditions took hold in the UK, the US, and several other developed economies. 

Economists argue about the exact causes. One contributing factor was high oil prices, which drove up both prices and costs, squeezing profit margins. Meanwhile, clumsy attempts by governments to control prices actually exacerbated inflationary pressure by making it harder for production to rise to match demand. 

Stagflation is difficult for policy makers to tackle. High inflation makes it hard for central banks to cut interest rates with the aim of stimulating the economy. Yet raising rates to tackle inflation will only exacerbate weak growth.

The 1970s stagflation also gave rise to the “misery index”. This was created by US economist Arthur Okun as an informal way of measuring the amount of economic pain the average American was feeling. The misery index simply adds the unemployment rate to the inflation rate. The higher it goes, the grimmer the situation.

Stagflation is also pretty miserable for investors. Squeezed profit margins are bad for stocks, but rising inflation is bad for bonds. That leaves few places to hide. 

The term is being muttered again now because supply chain disruption in the wake of the Covid-19 pandemic is driving up prices. Meanwhile, unemployment remains stubbornly high.

Here’s hoping we don’t see a repeat of the 1970s.   

To learn more about how to protect your portfolio from stagflation, subscribe to MoneyWeek magazine.

Recommended

Which companies will lose the most from the energy windfall tax?
Energy stocks

Which companies will lose the most from the energy windfall tax?

The government’s new energy windfall tax has muddied the waters for investors and companies alike. Rupert Hargreaves explains how it might affect some…
27 May 2022
The MoneyWeek Podcast with Russell Napier at the Library of Mistakes
Investment strategy

The MoneyWeek Podcast with Russell Napier at the Library of Mistakes

Merryn talks to Russell Napier about Edinburgh’s Library of Mistakes, the age of debt and financial repression, plus why he has never invested in Chin…
27 May 2022
Cryptocurrency roundup: another torrid week for crypto
Bitcoin & crypto

Cryptocurrency roundup: another torrid week for crypto

Cryptocurrencies suffered yet another intense week. Saloni Sardana rounds up the week's crypto news.
27 May 2022
Ocado faces a “crunch” year – should you buy or avoid?
Share tips

Ocado faces a “crunch” year – should you buy or avoid?

Ocado was one of the big winners from the pandemic as customers moved online. But now it’s struggling, and losses are growing. So, asks Rupert Hargrea…
27 May 2022

Most Popular

The world’s hottest housing markets are faltering – is the UK next?
House prices

The world’s hottest housing markets are faltering – is the UK next?

As interest rates rise, house prices in the world’s most overpriced markets are starting to fall. The UK’s turn will come, says John Stepek. But will …
23 May 2022
The Federal Reserve wants markets to fall – here’s what that means for investors
Stockmarkets

The Federal Reserve wants markets to fall – here’s what that means for investors

The Federal Reserve’s primary mandate is to keep inflation down, and lower asset prices help with that. So, asks Dominic Frisby – just how low will st…
25 May 2022
Scottish Mortgage Investment Trust has fallen hard. But is now the time to buy?
Investment trusts

Scottish Mortgage Investment Trust has fallen hard. But is now the time to buy?

After a spectacular couple of decades, the Scottish Mortgage Investment Trust has fallen by almost 45% so far this year. Rupert Hargreaves asks if no…
26 May 2022