Recession appears to be knocking on the door again. Most economists accept that a downturn is coming following a period of interest rate increases, persistently high inflation, stock market volatility, and muted economic growth. Opinions vary on how savage it might be, however. Some claim that a soft, brief recession is in store. Others fear that we could be in for a much harder time.
One topic that's been making the rounds 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.
Key Takeaways
- Stagflation is a stagnant economy combined with high inflation.
- It's a killer combination that can result in an economic downturn in which bills and the cost of living keep rising.
- These types of economic crises are often caused by big supply shocks and easy monetary policy. They last longer than "regular" recessions because there’s no definitive cure.
- Interest rates are normally cut to stimulate economic activity when a recession strikes but
central banks can’t easily do that when inflation is soaring. - Some economists fear that the U.S. economy is heading for stagflation for the first time since the 1970s.
What Is Stagflation?
Stagflation is a word that implies a combination of "stagnant” and “inflation.” It describes a period of low to nonexistent economic growth coupled with rapidly rising prices.
The Difference Between Stagflation and Recession
A recession is generally said to be in motion when there have been two consecutive quarters of negative economic growth. Stagflation is much more open to interpretation because it's rarer.
A stagnant economy isn’t necessarily one that's in a recession. The term “stagnant” implies sluggishness and a lack of activity that could mean either a full-blown downturn or just very weak growth. The level of inflation isn’t defined either, but we can assume that 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. They happen quite often and historically last just less than a year. Stagflation is uncommon and 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.
High inflation is normally associated with economic growth. It can be culled by hiking interest rates. Stagflation is harder to tame.
What Causes Stagflation?
It’s generally agreed that the main cause of stagflation is a major supply shock. Things tend to get off-kilter when the supply of food, oil, or something else that’s essential is disrupted and no longer able to meet demand. The situation is often made worse by poor economic policies.
Supply shocks lead prices to rise, hurting businesses, consumer finances, and economic growth. Central banks respond as they normally do to economic turmoil by making sure money is cheap to borrow so they essentially feed the flames of inflation, stimulating demand and pushing prices up further.
The term “stagflation” was first used in 1965 by British politician Iain Macleod.
History of Stagflation
The U.S. has only experienced a serious case of stagflation once in the 1970s when the supply of oil tailed off drastically and prices consequently rocketed. This occurred 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.
These events caused inflation to spiral out of control and threw the economy into disarray, along with easy monetary policy that the American central bank, the Federal Reserve, pursued to lift employment. Very high interest rates and a nasty recession were necessary to restore order and the stock market got crushed.
Will Stagflation Return in 2024?
Some fear that a similar situation could unfold again in 2024. Inflation is unusually high and the economy isn't firing on all cylinders. A combination of unique, random factors is largely to blame.
The COVID-19 pandemic led to a lockdown and a halt in production followed by surging demand when restrictions were lifted. Then Russia invaded Ukraine, causing yet more supply chain issues and leading oil prices to spike. Each of these unlikely, destabilizing events occurred when interest rates were historically low and money was extremely cheap to borrow.
The 2024 economy got off to a bit of a limping start, growing at 1.6% compared to 3% in 2023. Business investment and consumer spending grew about 3%, however, and these are powerful economic components. Stagnation is becoming less of a threat.
Other factors that contribute to stagflation include high debt, protectionist trade policies, an aging population, geopolitical tensions, climate change, and cyber warfare. Some of these aren’t going away so stagflation could continue to threaten.
The 2024 economy is not technically in a recession. Many economists agree, however, that higher unemployment could rear its head again and become a reality as loftier costs to service debt tempt companies to lay off employees. Stagflation can result when a lot of people are out of work and sluggish economic growth with high inflation combine.
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. His opinion isn’t shared by everyone, however. Stanford economist John Cochrane is hopeful that inflation likely will go away and the risk of stagflation will be averted.
A lot depends on the effectiveness of interest rate rises curtailing demand and whether major supply shocks can be ironed out quickly. The U.S. and global economies could face more than just a regular recession if inflation doesn't ease.
Central banks ease monetary conditions when the economy is heading toward recession. They can’t do that when inflation is high, however, and that’s potentially worrying.
Why Is Stagflation Bad for the Economy?
Stagflation is a combination of three negatives: slow economic growth, higher-than-normal unemployment, and expensive costs of living.
Interest rates are typically cut to get companies hiring again and the economy back up and running. but that action can be dangerous when inflation is soaring. We're left with people and companies strapped for cash at a time when higher prices to service their debts and obligatory purchases cost more and more each week or month.
This isn't just an extremely uncomfortable environment to live in but also quite tricky for governments to fix. Stagflation can drag on for years with no easy cure, causing heavy damage to the economy.
Stagflation can make a regular recession seem like a walk in the park. Prices rise rather than stay flat or fall and the tools normally used to fix the economy are ineffective. This discomfort may last for a long time.
The consequences of stagflation can be catastrophic. As Roubini points out, private and public debts are much higher than they were in the past, accounting for about 350% of global gross domestic product (GDP). This is changing and a storm is brewing with higher borrowing costs threatening to push leveraged households, companies, financial institutions, and even governments into bankruptcy and default.
We could find ourselves in an economic crisis like no other if events pan out as Roubini envisions with 1970s-style stagflation potentially being accompanied by a debt meltdown similar to the 2008 Great Recession.
Is Stagflation Worse Than a Recession?
Yes. Stagflation is basically like a recession with the added headache of rising prices and costs to service debt. There's no definitive cure so it's harder to defeat and it can last a long time.
Is It a Good Idea to Buy a House During Stagflation?
It could make sense to buy now rather than wait if prices continue to rise but lackluster economic growth might also weigh on house prices while the high interest rates necessary to combat inflation will mean less favorable borrowing terms. A lot depends on individual circ*mstances, what rate you’re offered, and how long peak inflation persists.
What Investments Perform Best During Stagflation?
Not many traditional asset classes fare well in this kind of environment. The best performers would probably be those with inflation-hedging characteristics such as inflation-indexed bonds, gold, and possibly real estate.
The Bottom Line
Many of us may 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 remained 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.
