Economists have since identified many potential factors that influence stagflation including a sudden supply shock and harmful government policies. Periods of stagflation were prevalent in the 1970s and 1980s in most major economies. This surprised economists as the dominant economic theory of the time, Keynesian macroeconomic theory, posited that increases in inflation and unemployment couldn’t happen at the same time.
Central banks in both America and Europe are struggling to deal with inflation. In the neoclassical viewpoint, the real factors that determine output and unemployment affect the aggregate supply curve only. Typically, inflation goes hand-in-hand with economic growth, and an overheated economy is one possible cause of higher inflation. In an economy running hot by operating above its long-term potential, price increases are necessary to ration labor and other scarce inputs and to offset those increased production costs. Meanwhile, a contracting economy with lots of spare capacity restrains price hikes and wage increases as demand slows. Those supply shocks followed a period of accommodative monetary policy in which the Federal Reserve grew the money supply to encourage economic growth.
She noted that the U.S. gross domestic product shrank at an annual rate of 1.4% over the first three months of this year, even as inflation remained historically high. But Harvey disagrees, saying stagflation hasn’t arrived but poses a real threat. In 1980, the Federal Reserve, led by chair Paul Volcker, raised the Fed funds rate to as high as 21%.
Demand-pull stagflation theory
Once the controls were relaxed, the rapid acceleration of prices led to economic chaos. In October 1973, the Organization of Petroleum Exporting Countries (OPEC) issued an embargo against Western countries. This caused the global price of oil to rise dramatically, therefore increasing the costs of goods and contributing to a rise in unemployment. Since that time, inflation has proved to be persistent even during periods of slow or negative economic growth.
- For those who are employed, stagflation could lead to risks of job losses and lower wages, which would decrease consumer confidence and purchasing power.
- According to this theory, periods of mergers and acquisitions oscillate with periods of stagflation.
- Consumers continue to spend at a healthy clip despite higher prices and businesses continue to hire.
- Even before the 1970s, some economists criticized the notion of a stable relationship between inflation and unemployment.
A wage-price spiral seemed improbable for decades after Paul Volcker’s Fed tamed inflation in the early 1980s, bringing stagflation to an end. In the aftermath of the 2007 to 2008 Great Recession and financial crisis and until 2021, inflation mostly fell short of the Fed’s targets amid lackluster economic growth. Inflation is the broad rise in the price of goods and services across the economy. The Federal Reserve deems annual inflation averaging 2% over the long run most consistent with its mandates of stable prices and maximum employment because that keeps the much more dangerous deflation at bay while supporting economic growth.
Supply Shock
Stagflation can sometimes correct over time and interventions to try to end it could lead to recessions with dramatic declines in GDP. Different national policies for tackling stagflation might also impact global trade as these policies create different conditions for recovery that might conflict. Finally, even if the pace of economic growth slows, investors should focus on tweaks to their asset allocations rather than wholesale changes. “Don’t panic and do something foolish, still kind of stay the course,” Bond says.
The best performers probably will be those with inflation-hedging characteristics, such as inflation-indexed bonds, gold, and possibly real estate. If events pan out as Roubini envisions, we could soon find ourselves in an economic crisis like no other, with 1970s-style stagflation potentially being accompanied by a debt meltdown similar to the 2008 Great Recession. Just the thought of a mixture of these downturns, two of the worst on record, is enough to send shivers down the spine, Roubini writes. Other factors in some way contributing to today’s stagflation include high debt, protectionist trade policies, an aging population, geopolitical tensions, climate change, and cyber warfare. And some of these aren’t going away, meaning stagflation could be here to stay for a while. “The danger of stagflation is considerable today,” the World Bank warned this week.
They can’t do that now, though—inflation is high, and that’s potentially very worrying. Economist Nouriel Roubini is convinced that the Federal Reserve and other central banks’ attempts to curb inflation will lead to a hard landing and a grueling stagflationary debt crisis. Stanford economist John Cochrane, for example, is hopeful that inflation likely will go away and the risk of stagflation will be averted. As in the 1970s, supply shocks have significantly worsened inflation over the past 18 months. COVID-19 played a major role, with exporting nations shutting down or curbing production of cars, electronics and other goods and shipping companies taking months longer to deliver them.
For example, the increase in inflation in 2021 and 2022 reflected the demand-pull effect of the fiscal stimulus in U.S. pandemic relief legislation, as well as the cost-push of supply chain disruptions, including sharply higher shipping costs. The inflation of the 1970s has been variously attributed to the cost-push of oil price shocks and the demand-pull of relaxed fiscal and monetary policies. Government policies regulating the economy can also have an impact as shown by the Nixon strategy of devaluing the dollar and instituting wage and price freezes known as the Nixon Shock. Ultimately, central banks and legislators struggle with how to tackle stagflation since interventions to support their objectives of price stability, low unemployment, and economic growth can conflict. As a result, prices rise in response to expansionary monetary policy without any corresponding decrease in unemployment, while unemployment rates rise or fall based on real economic shocks to the economy.
Neoclassical Responses
For example, if inflation is at 5% and you currently spend $100 per week on food, the following year you would need to spend $105 for the same groceries. Stagflation could impact international trade by increasing global commodity prices for everything including food, making it much more expensive to do business and increasing inflation further. National or global unemployment can also reduce global economic output, consumer confidence, and spending – increasing unemployment in more areas because of the interconnectedness of global trade.
If supply-chain snags were to ease, making cars, electronics, food and fuel more plentiful, prices would fall quickly, said Chester Spatt, professor of finance at Carnegie Mellon University’s Tepper School of Business. In short, the economy does not currently face stagflation, Hunter and other economists told CBS MoneyWatch, although slower growth is a concern looking ahead. In its strictest sense, stagflation refers to a stretch of rising unemployment coupled with sharply increasing prices. On rare occasions, however, high inflation persists even as the economy slows and unemployment rises, resulting in stagflation, she said.
Cost-push inflation results when producers are able to recoup their increased costs by increasing the price of finished products. If input costs rise as a result of a temporary disruption in supply such as factory closings caused by a pandemic, for example, policymakers may reasonably assume the price pressures will prove temporary as well. Demand-pull inflation happens when demand for goods and services rises above the economy’s capacity to meet it. The law of supply and demand suggests demand will moderate in that case only in response to higher prices.
The level of inflation isn’t defined either, although we can assume it has to be at least above the 2% threshold set by most central banks in advanced economies. So far this year, the Fed has increased its target interest rate twice, and it appears ready to hike it at least three more times before the end of 2022. Higher borrowing costs have already had an effect on the housing market, with mortgage rates rising from about 3% in January to 5% today. That’s dramatically reduced mortgage applications while slowing home purchases, data show.
The risk is that the Fed’s rate hikes end up quashing growth, rather than merely dialing it back, triggering a recession. Gold performed well in the 1970s, as it and other precious metals are seen as a traditional hedge. Commodities also performed well, particularly oil (of course, there was an embargo) and other commodities of limited supply. Keynes detailed the relationship between German government deficits and inflation. Keynes explicitly pointed out the relationship between governments printing money and inflation. Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.
This implies that attempts to stimulate the economy during recessions could simply inflate prices without promoting real economic growth. Critics of this theory point out that sudden oil price shocks like those of the 1970s did not occur in connection with any of the simultaneous periods of inflation and recession that have occurred since the embargo. In mid-2022, many were saying that the United States had not entered a period of stagflation, but might soon experience one, at least for a short period. In June 2022, Forbes magazine argued that a period of stagflation was likely because economic policymakers would tackle unemployment first, leaving inflation to be dealt with later. When the economy is heading toward recession, central banks ease monetary conditions.
It’s also a conundrum for fiscal and monetary policymakers, as it turns the Phillips curve on its head. Although the U.S. eventually overcame the stagflation scourge of the 1970s—after a decade of economic doldrums—the causes of stagflation and the best solution for overcoming it remain a matter of debate. https://www.dowjonesrisk.com/ According to this theory, periods of mergers and acquisitions oscillate with periods of stagflation. When mergers and acquisitions are no longer politically feasible (governments clamp down with anti-monopoly rules), stagflation is used as an alternative to have higher relative profit than the competition.