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.

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