Everything You Need To Know About Stagflation

July 27, 2023
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Stagflation is a financial cycle that has been defined by weak development, persistent joblessness, and the rate of inflation. Financial officials find this combination especially challenging to manage since correcting one condition might aggravate another. Stagflation, formerly considered inconceivable by analysts, has frequently occurred in advanced nations since the 1970s oil disaster. Many people believed that the United States wasn't yet going through a stagflation phase but would shortly, possibly for a brief period. Forbes magazine claimed in June 2022 that stagflation was inevitable since authorities in the economy would prioritize addressing unemployment before addressing inflation.

What is stagflation?

Stagflation occurs when an economy experiences weak development, high unemployment, and price increases, all at the same time. Stagflation, formerly considered to be unfathomable by economists, has frequently transpired in industrialized nations since the 1970s. Policy responses to weak development tend to exacerbate inflation, and the reverse is true. This makes combating stagflation difficult. When high inflation is combined with a period of stagnation, the economy is said to be in a condition of stagflation. Costs for services and products rise over these periods, but economic development is slow, and rates of unemployment climb. In simple terms, costs are growing but buying power remains stagnant.

A slowing economy generally reduces consumer demand for products and services, causing prices to fall. However, the two traits of stagflation exacerbate each other. Stagflation is extremely challenging to reverse once it has begun. When economic development slows or an economic downturn occurs, the Federal Reserve can change monetary guidelines to boost expenditure to revitalize slow economic growth. However, in a moment of stagflation, lowering interest rates to promote expenditure will increase inflation, making problems more serious. Rather, stagflation necessitates a far more long-term strategy for fiscal policy change.

The concept of stagflation

The three economic elements that comprise stagflation are crucial to understanding how it works: stagnation, a rise in inflation, and elevated unemployment rates. Slow growth leads to a high rate of unemployment in a sluggish economy. Lower salaries arise from more individuals competing for fewer jobs. At the same time, excessive inflation raises the cost of products and services, lowering customers' purchasing power.

During stagflation, bonds and equities underperform, resulting in losses for investors. Stock prices are suppressed when growth is slow, while bonds suffer when inflation is strong.

In the 1970s, the Federal Reserve's solution to stagflation was expanding government expenditures to attain full employment. This strategy increased inflation while failing to address the employment crisis. The Great Inflation resulted in a worldwide downturn characterized by poor or declining economic growth and widespread joblessness. It is yet to be known if the current economic state will suffer an identical outcome during stagflation.

History of stagflation

Stagflation was formerly thought to be unfathomable. The economic ideas that ruled policies and academia excluded it from their frameworks for the entire twentieth century. The Phillips Curve economic concept, which emerged in Keynesian economic theory's framework, depicted the macroeconomics policy as an agreement between unemployment and inflation.

As an outcome of the Great Depression and the rise of Keynesian economics, economists were worried about the hazards of deflation, arguing that most measures aimed at lowering inflation boosted unemployment. While policies aimed at lowering unemployment increase inflation.

The emergence of stagflation in the industrialized nations towards the end of the twentieth century demonstrated that this was not the case. Stagflation is an excellent example of how everyday life can trample on commonly held economic theory and policy recommendations.

Inflation has remained consistent since then, even during weak or low economic development periods. Every proclaimed crisis in the United States during the last 50 years has seen an annual rise in consumer expenditure levels. The single exemption is the bottom period of the economic meltdown in 2008, and by then, the cost decrease was limited to energy and transportation expenses, while overall consumer prices other than energy continued to grow.

The misery index

A misery index was used to depict the impacts of stagflation. This index, just the sum of the inflation and unemployment rates, monitored the real-world consequences of stagflation on a country's population due to the threat of (or actual) unemployment paired with rising living costs.

Because inflation and joblessness are regarded as damaging to one's financial stability, their combined worth is valuable as an indication of overall financial stability. The original misery index gained popularity in the 1970s, during the rise of stagflation, or a spike in inflation and joblessness.

What causes stagflation

According to Keynesian economists, stagflation is caused by shocks to the energy or food supply, such as rises in the cost of oil. According to monetarists, stagflation is caused by a nation's fast cash supply growth. According to supply-side economists, stagflation is caused by stringent corporate rules and elevated taxes.

·       Shocks to the oil price

According to one idea, stagflation occurs when a rapid spike in the cost of oil decreases an economy's ability to produce. The 1970s oil crisis is a great instance. The Organization of Petroleum Exporting Countries (OPEC) imposed an embargo on Western countries in October 1973. This led worldwide oil costs to skyrocket, raising the cost of commodities and increasing unemployment. Producing things and delivering them to stores got more costly as the cost of transport grew, and prices rose even as employees got laid off.

·       Poor economic policies

Another argument contends that the combination of stagnation and inflation results from weak economic policy. Stagflation may be caused by harsh control of markets, products, and personnel in an otherwise inflationary environment. Some blame former President Richard Nixon's actions for the 1970 recession, which might have been a prelude to subsequent stagflation episodes. To keep costs from increasing, Nixon imposed taxes on importation and suspended wages and prices for 90 days. The quick escalation of prices when the limits were lifted caused economic pandemonium. While attractive, this is a necessary account for the 1970s stagflation that fails to clarify succeeding periods of parallel stagflation.

·       The loss of the gold standard

Other hypotheses suggest that monetary variables may also contribute to stagflation. Nixon abolished the final indirect remnants of the gold standard, putting the Bretton Woods system, which was regulating exchange rates of currencies, to an end. This move eliminated the money's commodity underpinning and placed the US dollar and the majority of international currencies on a paper-based foundation, removing the most practical limitations on monetary growth and currency depreciation.

·       Robust trade unions

If trade unions have significant negotiating strength, they may be able to negotiate greater salaries even during periods of slower economic development. Wage increases are a major source of inflation.

·       Declining performance

When an economy's efficiency falls, employees become less efficient, costs rise, and output falls.

·       Increase in persistent unemployment

If established industries collapse, we may see higher rates of joblessness and decreased production. As a result, even though inflation increases, unemployment might increase.

·       Supply disruptions

If supply networks are disrupted, prices will begin to rise. Unemployment will also fall as a result of the supply shock. For instance, supply disruptions in the United Kingdom triggered moderate stagflation in 2021.

Remedies to stagflation

Stagflation cannot be solved easily; however, the following solutions might help:

   i. Monetary policy may typically be used to either decrease inflation (by raising interest rates) or enhance economic growth (by lowering interest rates). Monetary policy cannot address both economic downturn and inflation simultaneously.

   ii. Lowering the economy's reliance on oil is one way to make it less susceptible to stagflation. Rising oil costs mostly cause stagflation.

   iii. The only true answer is to boost productivity through supply-side measures, which allow for greater development without inflation.

   iv. The Central Bank maintained low-interest rates (0.5%) in 2010/11, believing poor growth was a larger concern than transient cost-push inflation.

Relevant considerations

Most policymakers and economists have reached a de facto agreement on stagflation, redefining what they imply by the concept of inflation in the current era of financial and economic systems. Inflation is simply the result of consistently increasing price levels and declining buying power, natural phenomena in both good and poor economic periods.

Policymakers and economists often expect prices to increase and are more concerned with rising and declining inflation than with inflation itself. The striking periods of stagflation in the 1970s may now be considered significant references. However, concurrent economic standstill and rising prices appear to be the current norm in financial crises.

Stagflation versus Inflation

Whatever the cause, inflation has persisted even through times of economic decline since the 1970s. Some economists questioned the idea of a steady link between inflation and unemployment even before the 1970s. They contend that buyers and sellers adapt their economic conduct in response to or anticipate fiscal policy changes. As a result, prices rise in reaction to expansive monetary policies without commensurate reductions in unemployment. Still, unemployment rates rise or fall in response to actual economic shocks to the economy. This means that efforts to stimulate the economy during a recession may only increase prices rather than promote actual economic development.

Examples of stagflation frequently asked questions

What is the root cause of stagflation?

Economists disagree on the underlying causes of stagflation. When supplies are imbalanced, the scene is often prepared for stagflation. It is an unforeseen event, such as an oil supply interruption or a scarcity of critical parts. During the COVID-19 epidemic, there was a disturbance in the delivery of semiconductors, which hindered manufacturing all things, from laptops to vehicles and appliances. A magnitude shock can impact all factors contributing to stagflation: inflation, employment, and economic growth.

What is the impact of stagflation on businesses?

Stagflation puts a strain on businesses, particularly those with limited resources. When the cost of materials rises, firms may raise their pricing while remaining competitive, certain that other businesses are experiencing the same problem. Customers cannot afford to shell out more for goods during stagflation because more people are lacking work, and salaries are not rising. During stagflation, firms frequently encounter labor disturbances as employees seek greater compensation in the face of rising prices. On the other hand, employers cannot afford to boost pay while sales are down. Consumers cannot spend, companies have fewer consumers, and the cycle continues.

How does one combat stagflation?

The remedy for stagflation was discovered in the 1970s by the same person who initially diagnosed the problem: Robert A. Mundell. Mundell's strategy is straightforward: cut taxation rates for businesses and people to improve their direct purchasing power while limiting the range of money to loan. The two concurrent strategies increase demand for available money, making it greater value with restricted supply while simultaneously curbing inflation.

Will there be another round of stagflation?

Stagflation, predicted by some analysts, will not occur again. Many analysts believed stagflation was a serious threat after the Paycheck Protection Program, higher unemployment payouts, and supply chain concerns spurred inflation. It did not occur. However, the Russian war, ongoing supply chain disruptions, and an uncertain stock market make long-term forecasting problematic. The political impasse can have economic consequences because of leadership concerns and shifting power dynamics in Washington. The basic schools of thinking on economic policy remain fundamentally constant, although policymaking is becoming increasingly difficult due to political conflict. If stagflation occurs, lawmakers may be unable to move fast or agree on a solution.

How can one prepare their business for stagflation?

Smart business owners are now adapting their strategy for future stagnation or disaster to render their firms disaster-proof. Moving assets into lower-growth but recession-resistant areas like healthcare, consumer staples, utilities, and discount retail, or guaranteeing personnel elasticity in the recruiting process, may equip your company to weather even the most severe economic storm. Though governments may be powerless to alleviate the pain of increasing prices in the absence of development, entrepreneurs ought to prepare to mitigate the effect of stagflation on their businesses.

Conclusion

Stagflation is the simultaneous occurrence of weak economic development, price hikes (inflation), and increasing joblessness. Financial analysts have long debated what triggers stagflation and how to react effectively. Although there are several possibilities, they are all strongly disputed. Stagflation is difficult since it makes it challenging for central banks and governments to adapt properly.