Stagflation: Definition, origin and solution

Glossary

What is the meaning of stagflation?

Stagflation is a combination of two negative economic trends: stagnation and inflation. Stagflation is a situation where the economy stagnates and prices rise (inflation). In a period of stagflation, costs for consumers rise, while employment decreases and economic growth slows down.

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Where does the term stagflation come from?

The term ‘stagflation’ was likely first used in 1965 by British politician Iain Macleod. He used it to describe the economic situation in the UK during a period of stagnation with simultaneous inflation. It became particularly well-known during the oil crisis of the seventies, when oil prices rose enormously, leading to both stagnation and inflation worldwide.

Stagflation vs. inflation

Although stagflation and inflation both relate to rising prices, they are not the same. Inflation is the gradual, general price increase of goods and services over a certain period, while stagflation is a combination of stagnation (slow or no economic growth) and high inflation.

The history of stagflation

Stagflation became a well-known phenomenon in the seventies. The first and second oil crisis caused by the OPEC countries and unrest in the Middle East, led to a global rise in oil prices. This caused the cost of energy – and thus almost all products – to become significantly more expensive. Resulting in a wage-price spiral and low growth, which made life more expensive for consumers and put companies under pressure. The situation was difficult for governments and central banks, because it was long thought that inflation and stagnation did not go together. Fighting stagnation with policy would worsen inflation, and vice versa.

The end of stagflation in the seventies

The crisis was only ended in the early eighties by the American central bank, led by Paul Volcker, who drastically raised interest rates to break inflation. Although this harsh measure caused a short, severe recession, it succeeded in stabilizing inflation expectations and freeing the economy from the grip of stagflation.

The most recent signs of stagflation were in 2022, when oil and gas prices rose sharply due to the war in Ukraine.

How can stagflation arise?

Stagflation can arise in two ways: commodity prices that suddenly increase sharply or unfavourable monetary policy. 

1. Higher commodity prices

Usually, this is caused by external supply shocks, such as a sudden rise in commodity prices like oil or gas due to conflicts or natural disasters. These shocks lead to higher costs for companies, resulting in rising prices for consumers. A cappuccino that initially cost €2 has become €4 due to the increase, for example. At the same time, it becomes harder for companies to make a profit due to those higher costs, leading to a decrease in production and employment.

2. Unfavourable monetary policy

Unfavourable monetary policy can also cause stagflation. The central bank increases the money supply enormously, while the government simultaneously hinders companies and damages the industry. This dilemma makes it very difficult for policymakers to fight stagflation, because one policy damages the economy and the other policy causes the value of money to drop.

How do you notice stagflation?

You notice stagflation in daily life through a combination of high prices and economic stagnation. For instance, there is high unemployment and it is harder to find a new job, because companies make no or less profit. They are therefore forced to lay off staff. In addition, the prices of basic needs like food and energy rise. Higher inflation causes significant loss of purchasing power for consumers. Also, the economy does not grow, meaning no new jobs are added and companies can hardly invest. The combination of unemployment and rising costs makes it difficult for many people to get ahead.

How do you solve stagflation?

Stagflation can cause an economic dilemma and is difficult to solve, because the usual measures against inflation can further weaken the economy, while measures to stimulate the economy can fuel inflation. Yet there are three possibilities:

1. Lower interest rates: Central banks often lower interest rates to pull a stagnating economy out of the slump and put more money into circulation. The goal is to stimulate people to spend and invest more money. So more money enters circulation to give the economy a push in the right direction.
2. Raise interest rates: When inflation is high, central banks often raise interest rates to cool down the economy. There is high demand for products and services, and companies cannot keep up with demand. Scarcity arises and inflation rises. A higher interest rate ensures that saving yields more and borrowing is less attractive, causing people to spend less money.
3. Tackle the core: Addressing the problem, such as looking for alternatives to sharply risen commodities or improving supply chains, can stabilize the situation.

The impact of stagflation on the stock market

Stagflation also influences the stock market, although this varies for publicly traded companies. Companies that provide essential products and services, such as healthcare, basic consumer goods, and utilities, usually suffer less from stagflation. Conversely, companies dependent on commodities generally have a harder time. Roughly speaking, because commodity prices rise during stagflation.

What should you do as an investor during stagflation?

As an investor, it is wise to understand that stagflation puts financial markets under pressure and can influence the value of your investments. Therefore, it is recommended to diversify your portfolio to spread the risk across various sectors. In addition, the advice is to be patient. Stagflation can cause volatility. Stick to your long-term strategy and avoid impulsive decisions.

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All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.