Many analysts and former Federal Reserve officials have recently warned of impending "stagflation" in the U.S. economy. It's clear from their attitude that stagflation is a very worrying trend, but what exactly is it?
One of the rarer economic conditions, stagflation is a phenomenon that 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 severely impactful it's important to thoroughly examine its causes and effects.
What is stagflation?
High inflation is seldom accompanied by a period of stagnation, but when the two coexist the economy is in a state of "stagflation." During these times, prices of goods and services increase while economic growth remains sluggish and unemployment rates are elevated. Typically, a slow economy would reduce demand for goods and services, driving prices down, but stagflation's dual-characteristics compound one another and threaten to deepen a growing crisis.
Rising prices put even more of a squeeze on unemployed people, or those living on a tight budget. As the unemployment rate rises along with prices, people who have been recently laid off are forced to eat into their savings more quickly. As consumer spending slows, businesses' revenues decline, and in turn 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, and it is only just beginning to lift rates back to normal levels 10 years later. 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 as well.
What causes stagflation?
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. Monetarists argue instead that 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. Generally, each of these factors influence stagflation, and a mixture of all three can send the economy into a tailspin.
History of stagflation
The term stagflation was first coined in the 1970s when the United States began experiencing inflation during a recession. A suspected cause of this particular instance are 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 lead to double-digit inflation rates in 1973 and 1974, as well as nearly doubled the unemployment rate. Naturally, consumer spending plummeted.
Now, some analysts 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 economic growth has remained lower than historic rates since the recovery, 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 argue this thinking is off the mark, however, citing low inflation rates and high consumer confidence. As it stands, the Fed has increased interest rates six times since December 2015 to their current level of 1.75 percent. Interest rates remain at historic lows, and the central bank thus far plans to press ahead as planned with periodic hikes.