Stagflation: definition, causes, and predictions

Fears of stagflation in the UK are increasing as business confidence collapses, supply bottlenecks tighten, energy prices rise, and winter fuel shortages add to fears. But what exactly is stagflation? And what could it mean for the economy?

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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.

The word stagflation is a combination of the terms stagnation and inflation, to describe the mixed economic environment. It’s generally attributed to Iain Macleod, who became UK Chancellor of the Exchequer in 1970 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. And stagflation is the mixture of the two, high inflation coupled with low growth and high unemployment.

What are the causes of stagflation?

Stagflation is caused by disruptive government policies that interrupt 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. For example, in early October 2021, we saw a massive hike in oil prices while supply has dropped off caused by a shortage of lorry drivers. The conflict between the increasing prices and reduced profits leads to stagflation.

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. The high inflation means that central banks can’t cut interest rates to stimulate the economy but raising rates to tackle inflation would only weaken growth.

Is stagflation coming?

Rising energy prices and supply-chain concerns have led to conversations about whether or not a period of stagflation is coming. The increase in prices – also known as inflation – without a subsequent rise in wages could force central banks to raise the costs of borrowing to rein in the economy. This would likely put a damper on gross domestic product (GDP) growth, at just the time when confidence is declining anyway.

Currently, US unemployment is sitting at around 5%, GDP is expanding and the Consumer Price Index – the most common measure of inflation – is up about 4%.

Central bank policymakers have spent the last couple of years trying to induce more inflation, keeping interest rates low and letting price increases run. But recently the fears that prices are increasing faster than they expected have meant that both the Fed and the Bank of England could move up their schedule for increasing interest rates.

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.

History of stagflation in examples

To better understand the causes and effects of stagflation, let’s take a look at a famous example.

UK stagflation 1970s

The most common comparison you’ll see is the ‘1970s-style stagflation’. This is a period when both the UK and 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.

Best investment for stagflation

Stagflation has proven to be a poor environment for investors. During the 1970s stagflation period, UK equities provided an annualised return of just 0.4%. That being said, there are a few asset classes that you could focus on in high inflation environments. For example, 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.

What’s important for investors and traders is managing the risk that comes with stagflation. This can be achieved through diversification, hedging, and attaching tools such as stops and limits.

If you’re a short-term speculator, you might want to consider short-selling stocks that decline in periods of high inflation or changing economic environments, such as cyclical stocks.

Take a look at our guide to inflation stocks.

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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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