what is stagflation caused by

Economists have long struggled to understand what causes stagflation and how best to intervene when it happens. Stagflation is a challenging problem to face, making it difficult for central banks and policymakers to respond effectively. Historically, Nixon’s ending of the convertibility of U.S. dollars to gold, which prompted the end of the Bretton Woods System, is theorized as one driver of 1970s stagflation.

In 1980, the Federal Reserve, led by chair Paul Volcker, raised the Fed funds rate to as high as 21%. This led to a painful 16-month recession and spike in the unemployment rate to 10.8%. Considering that stagflation is such an unusual and puzzling condition, there’s no guarantee that such an austerity fix would produce the same results in another stagflationary situation.

  1. At the time, there was a belief that high inflation led to low unemployment but during the 1970s unemployment and inflation both rose.
  2. And it forces central bankers and policymakers to devise new ways to solve the problem.
  3. The dramatic episodes of stagflation in the 1970s may be historical footnotes today.
  4. Periods of stagflation were prevalent in the 1970s and 1980s in most major economies.
  5. Keynes explicitly pointed out the relationship between governments printing money and inflation.
  6. In America, unemployment stood below 4% on the eve of the pandemic, with inflation also low.

He says that’s because the economy is fundamentally different today than it was back then. Economist Larry Summers, a former Treasury Secretary, argued in a March 2022 op-ed in The Washington Post that the Federal Reserve’s current policy trajectory would likely lead to stagflation and ultimately a major recession. While the U.S. has sidestepped another bout of stagflation since the 1970s, some commentators have drawn parallels between that episode and recent dynamics in the economy. While it’s unlikely that the U.S. economy is headed for another bout of stagflation, it’s important to contextualize what’s happening with the prominent episode of stagflation in the 1970s.

As Roubini points out, private and public debts are much higher than in the past, accounting for about 350% of global gross domestic product (GDP) because interest rates were low for ages. Now that this is changing, a storm is brewing, with higher borrowing costs threatening to push leveraged households, companies, financial institutions, and even governments into bankruptcy and default. At this point, a lot depends on the effectiveness of interest rate rises curtailing demand and whether major supply shocks can be ironed out quickly. If inflation doesn’t ease soon, then the U.S. and global economies could face more than just a regular recession. The term “stagnant” implies sluggish and lacking activity, which could mean a full-blown downturn or just very weak growth. 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.

Blame Poor Economic Policies

The sole, partial exception to this is the lowest point of the 2008 financial crisis—and even then the price decline was confined to energy and transportation prices while overall consumer prices other than energy continued to rise. The advent of stagflation across the developed world later in the 20th century showed that this was not the case. Stagflation is a great example of how real-world experience can run roughshod over widely accepted economic theories and policy prescriptions.

However, most economists now agree that the one thing missing, higher unemployment, could soon become a reality as loftier costs to service debt tempt companies to lay off employees. Match lots of people out of work and sluggish economic growth with high inflation, and you have stagflation. The bad policy theory believes that stagflation is often the result of bad economic policy. The central bank’s and government’s attempt to regulate the economy often leads to them making the wrong choices. For example, prior to the 1970s, the U.S. was focused on maximum employment across their economy after the Employment Act of 1946, which inadvertently caused inflation to increase and impacted employment and growth. Supply shocks can also be caused by labor restrictions which reduce output and raise unemployment and wages while causing prices to rise as businesses push the higher costs of labor onto consumers.

The gold standard made the U.S. vulnerable to runs on gold as there were more dollars in foreign hands than gold reserves in the U.S. In 1971, Nixon closed the gold window that allowed for the exchange of dollars for gold. Both moves devalued the dollar which impacted inflation and economic growth and led to stagflation.

And former Fed Chair Ben Bernanke said in May 2022 that the U.S. could be in for a period of stagflation. Fixed-income investors can turn to shorter-duration bonds and Treasury inflation-protected securities (TIPS), which adjust their principal to match inflation, to minimize the impact of rising inflation. Keynes detailed the relationship between German government deficits and inflation. Keynes explicitly pointed out the relationship between governments printing money and inflation.

Austrian School of economics

With no easy cure, stagflation can drag on for years, causing heavy damage to the economy. 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.

With increasing mergers and acquisitions, the power to implement stagflation increases. In economics, stagflation or recession-inflation is a situation in which the inflation rate is high or increasing, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment. The wage-price spiral, sometimes also called wage-push inflation or built-in inflation, describes instances when rising wages and prices reinforce each other, with higher prices driving wage increases which then result in still higher prices.

what is stagflation caused by

But if this is how the economy is supposed to work, stagflation is a puzzling paradox. And it forces central bankers and policymakers to devise new ways to solve the problem. Economist Friedrich Hayek proposed that governments fight inflation by ending expansionary monetary policies and waiting for prices to adjust via the free market. That means cutting back on things like expansions in the money supply and interest rate reductions. If stagflation is caused by rising wages, wage control could be implemented to limit rapid wage increases which are causing price inflation and reducing profit margins. A monetarist response to stagflation would be to reduce inflation even if it causes a short-term increase in unemployment and a decrease in economic growth.

When weighing big purchasing decisions—like a car, for example—consider whether you can defer or delay the purchase of items where prices may be temporarily elevated, he adds. Whether or not the U.S. will experience https://www.fx770.net/ another bout of stagflation remains to be seen. Haworth says that investors have been battling two headwinds—high inflation and rising interest rates—that don’t necessarily create a clearcut path for investing.

Inflation vs. Stagflation: An Overview

Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.

Dividend investors may also be negatively affected as companies reduce or suspend their dividends to conserve cash. For those who invest in growth stocks, there could be significant losses as many investors may have expected growth targets that stagflation would make it harder to meet. This is a combination that isn’t supposed to occur, in the logic of economics. Other theories point to monetary factors that may also play a role in stagflation. In addition to the World Bank, other major institutions—like Goldman Sachs and BlackRock—also warned about stagflation risks.

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. Real estate also served as a good hedge, as it was less correlated to stocks. In October 1973, the Organization of the Petroleum Exporting Countries (OPEC) declared an oil shipping embargo to the United States and Israel’s European allies in response to Western support of Israel during the Yom Kippur War. This decision removed commodity backing for the currency and put the U.S. dollar and most other world currencies on a fiat basis, ending most practical constraints on monetary expansion and currency devaluation. But stagflation never arrived, and McMillan isn’t worried about another episode happening any time soon.

As noted above, central banks like the Federal Reserve, often referred to as the Fed, and the European Central Bank (ECB) prefer modest inflation to none at all, as insurance against destabilizing deflation. Stagflation doesn’t respond to the conventional monetary tools based on the Phillips curve (see figure 1). According to the classic theory, when inflation is high, unemployment is supposed to be low, and vice versa. Many economists believe that the best thing to do in the face of stagflation could be nothing.