Stagflation: meaning, causes and examples

Canary Wharf London cityscape at night with HSBC building
Rebecca Cattlin
By :  ,  Former Senior Financial Writer

Fears of stagflation in the UK are increasing amid supply bottlenecks, energy shortages and cost of living fears. But what exactly is stagflation? And what could it mean for the economy?

What is stagflation?

Stagflation is the term for when a period of slow economic growth and high unemployment coincides with a rise in inflation. The situation often leads to a difficult economic policy, as any attempts to lower inflation could increase unemployment.

Stagflation meaning

The meaning of the word stagflation is just a combination of the terms stagnation and inflation, to describe the mixed economic environment.

The term is generally attributed to Iain Macleod, who became UK Chancellor of the Exchequer during a period of high inflation and high unemployment.

“We now have the worst of both worlds—not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation. And history, in modern terms, is indeed being made." – Ian Macleod, 1965

Difference between inflation, deflation and stagflation

Inflation is an economic environment defined by the rising prices of goods and services, and declining purchasing power of the local currency. It’s often met with higher interest rates. Deflation is the opposite of this: prices are falling in an economy and growth is low.

Stagflation is the worst of both worlds: it’s the rising prices of high inflation environments coupled with low growth of deflationary periods, which leads to rising unemployment.

Stagflation vs recession

While stagflation describes a period of little to no economic growth alongside high inflation and high unemployment, a recession is a period during which the economy actually shrinks. A recession is commonly defined as two successive quarters of declining gross domestic product (GDP).

Recessions are well-known parts of the economic cycle – periods of downturn generally follow periods of high growth. They’re usually sparked by a specific event such as market crashes, price spikes in essential goods or large interest rate hikes.

But stagflation is pretty rare because high unemployment and high inflation generally occur in separate parts of the cycle. High unemployment typically occurs alongside falling prices, as individuals tighten their belts and demand falls. While high inflation occurs when consumers have money to spend, and demand is high.

What are the causes of stagflation?

Stagflation is caused by disruptive government policies that go against normal market function. Usually, when there’s slow economic growth, inflation is low as consumer demand drops and prices are kept low.

But in certain periods of restrictive growth, governments intervene to create credit and increase monetary supply. One example would be both increasing taxes and lowering interest rates. The conflicting nature of these policies would both slow growth and increase inflation.

Another cause of stagflation is supply shocks – sudden increases or decreases in the availability of goods and services.

What are the effects of stagflation?

The effects of stagflation are considered to be worse than a recession because it combines high prices with fewer jobs and lower wages. These effects are particularly difficult to tackle because dealing with one problem will make the other worse.

If you raise rates to tackle the high inflation, you risk worsening the slow growth. If you lower rates to tackle the slow growth, you risk worsening the inflation.

Stagflation example: stagflation 1970s

The most common example of stagflation is the 1970s. This is a period when both the UK and the US – as well as other major market economies – went through an outbreak of inflation caused by the 1973 OPEC oil embargo. The soaring price of fuel nearly halted economic output and pushed the prices of goods and services up, the increased prices caused wage demands and inflation to spiral.

In the UK, inflation spiked from 9.2% in September 1973 to 12.9% in March 1974, while unemployment increased. As a result, the government rationed electricity, frequently cut power, and had an enforced three-day working week. In the US, there was a 9% unemployment, a contracting economy and a double-digit rise in inflation.

Are we experiencing stagflation?

Rising energy prices and supply-chain concerns have led to conversations about whether or not a period of stagflation is occurring.

For the US, successive Fed rate increases have caused consumer prices to slow down. And the employment rate is going up steadily, leading many to say they’re in the clear around stagflation concerns.

But in the UK, the increase in prices by around 8.7% (core CPI) has led the Bank of England to raise interest rates consecutively for 13 meetings, in an attempt to reduce consumer spending and rein in the economy.

But this has also put a damper on gross domestic product (GDP) growth, most recently shrinking by 0.1% between April and May 2023, just at a time when confidence in the economy is declining anyway.

Even though unemployment rates are low, the workforce has shrunk considerably due to a combination of factors such as Brexit, rising retirement rates and long-term illnesses. This means businesses are having to pay higher wages to retain staff, which just adds to prices rising for consumers.

The situation is made worse by the oil and gas supply issues caused by the Russian invasion of Ukraine.

So, if GDP remains low, while prices keep rising and interest rates go up, UK households will be able to afford less and less. Some are currently unable to pay rent or keep up with mortgages, leading to rising default levels.

Economists generally believe that the current situation is nowhere near the levels of stagflation that the UK saw in the 1970s, but that Britain is facing risks caused by the end of free movement and the declining labour market.

How to beat stagflation

Stagflation has proven to be a poor environment for investors because the uncertainty in the economy makes people less likely to want to put their capital into “risk-on” assets.

For example, during the 1970s stagflation period, UK equities provided an annualised return of just 0.4%.

The main way individuals try to achieve results or ‘beat stagflation’ is through assets that retain their value regardless of the state of the economy, rather than through high-growth trades. This typically includes stocks that operate in ‘defensive’ sectors and commodities that are deemed essential.

But the most important way for investors and traders to reduce the impact of stagflation on their portfolio is by managing the risk that comes from the uncertainty. This can be achieved through strategies such as diversification and hedging, and attaching tools such as stops and limits.

That being said, there are still ways for traders to find opportunities in stagflation. Let’s take a look at a couple:

Stagflation and equities

Value stocks are often characterised by outperformance during periods of high inflation. While certain sectors that are known as defensive stocks tend to bring in profits regardless of the state of the economy, such as consumer staples, energy, and real estate.

Plus, you can always look at using derivatives to short-sell companies that decline in periods of high inflation or changing economic environments, such as cyclical stocks.

Using indices can also provide a useful way of taking a position on the overall economic health of an economy or sector. For example, the FTSE 100 is used to measure the UK’s health, while the S&P 500 is regularly used as a barometer of US strength. So, if you took a long position, you’d be saying the economy is growing and if you went short, you’d be saying it will fall.

Stagflation and gold

Gold is often cited as a good hedge against inflation – as inflation rises, commodity prices spike.

While gold can protect against inflation, its reliability as a safe haven is dependent on the economic circumstances at hand.

For example, gold prices may not rise if quantitative easing programs are tapered and interest rates rise, as there’s a tendency for higher interest rates to send gold lower due to the increasing attractiveness of higher-yielding investments.

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Related tags: Inflation UK US Insights Equities

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