Why Is Stagflation Bad for the Economy?

Recession appears to be knocking on the door again. Most economists, following a series of interest rate increases, persistently high inflation, stock market volatility, and muted economic growth, have now accepted that a downturn is coming. However, opinions vary on how savage it will be. Some claim a soft, brief recession is in store, whereas others fear we are in for a much harder time.

One topic that has been making the rounds a lot lately is the prospect that we could be heading toward a period of stagflation. This has only happened once before in the United States, back in the 1970s, and it isn’t a pleasant experience.

What Is Stagflation?

Stagflation is a word that is a portmanteau of “stagnant” and “inflation.” It describes a period of low to nonexistent economic growth coupled with rapidly rising prices.

What’s the Difference Between Stagflation and Recession? 

A recession is generally said to be in motion once there have been two consecutive quarters of negative economic growth. Stagflation, on the other hand, is much more open to interpretation, mainly because it is rarer.

A stagnant economy isn’t necessarily one in a 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.

Two more key differences are time and frequency. Recessions are considered a normal part of the economic cycle, happen quite often, and historically last just under a year. Stagflation, meanwhile, is uncommon and, when it does rear its ugly head, tends to stick around. These types of economic crises are difficult to defeat because the traditional play of lowering borrowing rates to stimulate growth is taken off the table.

Normally, high inflation is associated with economic growth and can be culled by hiking interest rates. Stagflation is a different kind of animal that’s harder to tame.

What Causes Stagflation?

Based on the few examples we have witnessed so far, it’s generally agreed that the main cause of stagflation is a major supply shock. Should the supply of food, oil, or something else that’s essential be disrupted and become no longer able to meet demand, things tend to get off-kilter. Usually, the situation is then made worse by poor economic policies.

Supply shocks lead prices to rise, hurting businesses, consumer finances, and economic growth. And when central banks respond as they normally do to economic turmoil by making sure money is cheap to borrow, they essentially feed the flames of inflation, stimulating demand and pushing prices up further.

History of Stagflation

To date, the U.S. has only once experienced a serious case of stagflation: in the 1970s.

1970s

During the 1970s, the supply of oil tailed off drastically and prices consequently rocketed, first because of an embargo stemming from a war between Israel and the Arab states and later as a result of the Islamic revolution in Iran. Those events, along with easy monetary policy—which the American central bank, the Federal Reserve, pursued to lift employment—caused inflation to spiral out of control and threw the economy into disarray.

It took very high interest rates and a nasty recession to restore order. And, as you can probably imagine, the stock market got crushed.

Will Stagflation Return in 2023?

Today, there are fears that a similar situation could unfold again. Inflation is unusually high, and the economy is, well, not exactly firing on all cylinders.

How did we find ourselves in this situation? A combination of unique, random factors is mainly to blame. First, there was the COVID-19 pandemic, which led to a lockdown and a halt in production followed by surging demand once restrictions were lifted. Then Russia invaded Ukraine, causing yet more supply chain issues and leading oil prices to spike. And to top it all off, each of these unlikely, destabilizing events occurred when interest rates were historically low and money was extremely cheap to borrow.

Technically, the economy is not in a recession. 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.

So, are we doomed? Not necessarily. Economist Nouriel Roubini is convinced that the Federal Reserve and other central banks’ attempts to curb inflation will lead to a hard landing and a grueling stagflationary debt crisis. However, his opinion isn’t shared by everyone. Stanford economist John Cochrane, for example, is hopeful that inflation likely will go away and the risk of stagflation will be averted.

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.

Why Is Stagflation Bad for the Economy?  

Stagflation is a combination of three negatives: slow economic growth, higher-than-normal unemployment, and expensive cost of living. Whichever way you look at it, that situation is going to be painful.

Usually, to get companies hiring again and the economy back up and running, interest rates are cut. But when inflation is soaring, that action is dangerous, so you are left with people and companies strapped for cash while having to worry about higher prices to service their debts and obligatory purchases costing more and more each week or month.

This is not only an extremely uncomfortable environment to live in but also quite tricky for governments to fix. With no easy cure, stagflation can drag on for years, causing heavy damage to the economy.  

Should we soon find ourselves in this situation, the consequences could be catastrophic. 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.

If events pan out as Roubini envisions, we could soon find ourselves in an economic crisis like no other, with 1970s-style stagflation potentially being accompanied by a debt meltdown similar to the 2008 Great Recession. Just the thought of a mixture of these downturns, two of the worst on record, is enough to send shivers down the spine, Roubini writes.

The Bottom Line

Many of us will have experienced what living in a stagnant economy is like but will be unfamiliar with stagflation. Judging by its criteria and accounts from the 1970s, everyone would be better off if it remains history.

Imagine living in an economic downturn where people are losing their jobs while bills and the cost of living keep on rising. Stagnant growth and high inflation are a killer combo that can do great damage to an economy and leave scars for decades to come.