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What Is Stagflation? Inflation Plus Stagnation

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Business / Getty Images
  • Stagflation happens when the economy seems to be raising prices, currency is losing value, and no real growth is occurring to create jobs.
  • The economic condition is hard to control once it does set in because normal economic tools have no effect on it.
  • Tax cuts with restricted lending increase available cash for businesses and consumers while restricting the availability of borrowable funds. Companies then reduce prices to get business, and growth happens, creating jobs. 

Many analysts and former Federal Reserve officials have warned of impending "stagflation" in the U.S. economy. It's clear that stagflation is a very worrying possibility, but what, exactly, is it?

One of the rarer economic conditions, stagflation last occurred in the U.S. in the 1970s. The name is derived from its two characteristics: simultaneous inflation and economic stagnation. Taken together, these two conditions can have devastating effects on businesses in every industry.

Because stagflation is so uncommon, few understand just how destructive a period of stagflation can be. However, this vicious economic cycle is so detrimental that it's important to examine its causes and effects.

High inflation is seldom accompanied by a period of stagnation, but when the two do coexist, the economy is in a state of "stagflation." During these times, the prices of goods and services increase while economic growth remains sluggish and unemployment rates rise. Typically, a slow economy would reduce the demand for goods and services, driving down prices down. However, stagflation's dual characteristics compound each other and threaten to deepen a growing crisis.

Rising prices put even more of a squeeze on the unemployed or those living on a tight budget. As the unemployment rate rises along with prices, people who have been laid off recently are forced to go into their savings more quickly. As consumer spending slows, businesses' revenues decline, and business-to-business (B2B) companies suffer as well.

Once stagflation starts, it is extremely difficult to stop. When economic growth is slow or a recession hits, the Federal Reserve can alter monetary policy to encourage spending in a bid to stimulate sluggish economies. This is what the central bank did in the wake of the 2008 financial crisis. In a period of stagflation, however, pushing down interest rates to encourage spending will exacerbate inflation, ultimately making matters worse. Instead, stagflation demands a much more farsighted approach of reforming fiscal policies.

There are competing schools of economic thought regarding what causes stagflation. Keynesian economists argue that shocks to energy or food supplies, such as increases in oil prices, causes stagflation. Monetarists, on the other hand, say stagflation is the result of a rapid expansion of a country's money supply. Finally, supply-side economists believe stagflation is the combination of tight business regulations and high taxes. Each of these factors influences stagflation, and a mixture of all three can send the economy into a tailspin.

The term "stagflation" was coined in the 1970s, when the United States began experiencing inflation during a recession. Some suspect that this instance resulted from the policies of the Nixon administration, which heavily encouraged the Federal Reserve to increase the money supply parallel to the White House's strategy of implementing a series of wage and price controls. Those policies looked promising at first, but a sudden spike in oil prices crippled virtually every supply chain in the economy. The combination of all these economic and regulatory factors led to double-digit inflation rates in 1973 and 1974, and nearly doubled the unemployment rate. Naturally, consumer spending plummeted.

Now, some analysts, like Jim Paulson at the Leuthold Group, fear the U.S. is heading for stagflation once again. The Federal Reserve has initiated a series of interest-rate hikes in a bid to combat inflation. However, according to The Balance's reference list covering GDP levels from 1929 to 2019 economic growth has remained lower than historic rates since the recovery (2.3% growing in GDP for 2019), leading experts to fear that the market is unprepared for rising interest rates. If growth grinds to a halt, their reasoning goes, the Fed might be forced to keep interest rates artificially low, encouraging inflation along with declining growth rates. Some even warn it could cause a recession. Other analysts, like Neil Dutta, argue this thinking is off the mark, citing low inflation rates and high consumer confidence.

The cure for stagflation was also identified in the 1970s, by the very same person who identified the problem in the first place: Robert A. Mundell. His approach was eloquently phrased with lots of big words and economics-degree phrases, but in a nutshell, the solution was simple: cut tax rates for companies and individuals to increase their immediate buying power while restricting the availability of money to borrow. The two automatically create higher demand for the currency available, making it more valuable with tighter supply and breaking inflation simultaneously.

According to some experts, stagflation will not happen again.

Around 2018, many economists thought the markets were so inflated and heated that stagflation was all but ready to occur. But it didn't. Instead, the nation's economy just kept growing. As of early 2020, oil has the potential to be the trigger of U.S. stagflation, according to Matt Forester, the chief investment officer at BNY Mellon's Lockwood Advisors. Most likely, stagflation won't be the issue. Instead, a recession has a greater probability of occurring as the market retrenches in a healthy manner, at least from the collective CEO perspective according to Bart van Ark, chief economist at The Conference Board; the majority of CEOs surveyed peg a recession as their biggest 2020 concern.

The 2020 election also has the potential to have economic effects, due to leadership fears and changing power dynamics in Washington.

The market has to lose energy and go in the opposite direction at some point, which is what CEOs worry about most right now. The real question is when and how dramatic that negative direction will be.

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