Understanding Stagflation and its Causes, Effects, and Possible Policy Responses

What is stagflation, what does it mean and why is it so feared?

By Benjamin Talin Last updated Apr 30, 2024

Understand stagflation, its impact on the global economy and businesses, and the limited policy responses available to governments to combat stagflation and economic uncertainty.

In recent years, especially after notable increases in inflation and other economic disruptions such as COVID or wars, discussions often return to a term that, while not new, has gained renewed prominence – stagflation. This economic phenomenon, which uniquely combines stagnant economic growth, high unemployment, and rising prices, is causing widespread concern among economists, policymakers, and the general public. In contrast to more straightforward economic downturns such as recessions or depressions, stagflation presents a multi-faceted challenge that confounds traditional economic responses and solutions.

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What is Stagflation?

Stagflation is an economic condition characterized by the simultaneous occurrence of stagnant economic activity, high unemployment, and high inflation.

This combination is particularly troubling for economies because it defies the typical unemployment-inflation relationship depicted by the Phillips curve, where higher unemployment typically accompanies lower inflation and vice versa.

Defining the term “Stagflation”

The term “stagflation” is composed of the words “stagnation” and “inflation”. Stagnation refers to slow or no growth in an economy’s output, as reflected in measures such as GDP growth. Inflation, on the other hand, is the rate at which the general level of prices for goods and services is rising, resulting in a decline in the purchasing power of currency.

Economic conditions that lead to stagflation

Stagflation can occur under several scenarios, but it typically occurs when an economy experiences supply shocks – such as a sudden increase in the price of oil, energy, or other key inputs – combined with inappropriate policy responses that fail to address the underlying causes. These shocks can disrupt economic output without a corresponding reduction in price levels, squeezing consumers and businesses alike.

That is exactly what we have seen. After COVID, there was a large amount of excess money in the system, and the war in Ukraine sent a shockwave through the markets, leading to rapid inflation that continues to outpace current economic growth.

This unique economic situation often presents policymakers with a dilemma. Traditional monetary policies designed to curb inflation can exacerbate unemployment, while measures to reduce unemployment can lead to higher inflation, making stagflation a particularly intractable problem that leaves policymakers with no monetary policy alternatives. Of course, there are other ways to stimulate the economy, but most of these remaining policies have no immediate short-term impact.

Stagflation is rare – The History of Stragflation

Stagflation is not a frequent occurrence, but when it does manifest, it leaves a lasting impact on an economy. The most notable instance of stagflation till today occurred during the 1970s in the United States and other parts of the world, providing a critical case study for economists.

Stagflation in the 1970s

The stagflation of the 1970s in the U.S. was triggered primarily by two major oil shocks in 1973 (Arab oil embargo) and 1979 (U.S. embargo on Iranian oil), when oil-producing countries in the OPEC cartel significantly reduced oil production or embargoes led to supply shocks. This led not only to a sharp rise in oil prices, but also to a significant increase in the cost of goods and services in general, given the central role of oil in the economy. The situation was exacerbated by the U.S. government’s monetary policy at the time, which was not tight enough to control inflation.
This period of economic stagnation was characterized by high inflation rates, even exceeding 10% annually, coupled with unemployment rates that rose to uncomfortable levels. The economic policies implemented in response often struggled to strike a balance between reducing inflation and supporting growth, resulting in prolonged economic hardship.

Comparison with other economic downturns

Unlike typical recessions, which are primarily defined by a decline in economic activity and often lead to deflationary pressures, stagflation combines this decline with inflation. This anomaly makes traditional economic tools less effective, as measures to stimulate the economy may exacerbate inflation, while efforts to curb inflation may further depress economic activity.

We have seen this not only in the U.S., but in other economies during the same period, such as the U.K. and Japan, similar patterns of stagflation were observed, also influenced by global oil prices and similarly failed domestic policies. As seen, it is rare, but these historical cases provide valuable lessons on the complexities of managing an economy under the duress of stagflation and the limits of policy.

Causes of Stagflation

As noted above, stagflation results from a unique mix of economic factors that simultaneously inhibit growth and increase inflation. These causes, as well as the correlations, are important. In particular, fighting stagflation is difficult because it either raises inflation further or dampens growth – neither of which is conducive to ending the stagflationary period.

Economic factors that lead to stagflation

Supply shocks: Stagflation is often triggered by a sudden increase in the price of key commodities, such as oil. Supply shocks can severely disrupt production processes and increase production costs across a wide range of sectors, pushing up prices while slowing economic growth.
Poor monetary policy: Inappropriate or misguided monetary policies can exacerbate the effects of supply shocks or even create the conditions for stagflation. For example, an overly expansionary monetary policy can lead to inflationary pressures, while a tight policy can hinder economic growth.
Regulatory and fiscal policies: Over-regulation or high taxes can stifle business activity and economic efficiency, contributing to slower growth. When combined with high government spending, which can increase demand more than supply, inflationary pressures can rise, contributing to stagflation.
Global economic influences: In today’s interconnected world, international economic issues can also lead to stagflation. For example, global supply chain disruptions or geopolitical tensions affecting trade can lead to higher prices and reduced economic activity.
Political factors: Political instability or policy uncertainty can also lead to stagflation by affecting investor confidence and economic decision-making. When businesses are uncertain about future policy, they may reduce investment, slowing economic growth, while uncertainty itself may lead to speculative price increases.

Effects of Stagflation

We can imagine that slow growth and rising costs, also known as inflation, is a very difficult time for the economy and society. The double whammy affects different sectors and demographics in different ways. Here are the major effects in a stagflationary economic environment:

Effects on employment and incomes: One of the most immediate effects of stagflation is an increase in unemployment. As economic growth slows and businesses face higher costs, layoffs may increase, and job creation often slows or stops. This leads to a reduction in household income, which, combined with rising prices, severely affects consumers’ purchasing power and overall economic well-being.
Inflation and Cost of Living: Inflation during stagflation is particularly painful for consumers because it is not accompanied by a corresponding increase in wages. The rising cost of living can lead to a decline in the real value of money, making it more difficult for people to afford basic necessities. This scenario can lead to higher poverty rates and greater inequality, especially or poorer countries or developing nations.
Corporate performance and investment: For businesses, the high inflation associated with stagflation increases the cost of raw materials and other inputs, squeezing profit margins. Uncertainty about future economic conditions can cause businesses to delay or reduce investment, further dampening economic growth and innovation.
Government Fiscal Health: Stagflation can also put pressure on government budgets. Tax revenues may decline as a result of lower economic activity and employment, while demand for public services and welfare benefits increases. This can lead to higher public debt and potentially force governments to make difficult choices about spending cuts or tax increases.
Long-term economic growth: Prolonged periods of stagflation can have a lasting negative impact on an economy’s growth potential. The combination of reduced investment, lower consumer spending and declining productivity can stifle economic development for years.

The impact of stagflation on businesses

As you can imagine, when there is almost no growth in the economy but high inflation, it poses a lot of different challenges for businesses. This dual nature of stagnant growth and high inflation creates a vicious cycle that leads to less spending due to rising prices and rising prices due to increased cost pressures. Let’s take a deep dive into the implications and effects of stagflation on businesses:

Increased costs of production: High inflation typically leads to increased costs for raw materials, energy, and labor. During stagflation, these costs are exacerbated by economic stagnation, which reduces overall demand for products. As costs rise, profit margins are squeezed unless companies can pass these costs on to consumers through higher prices, which is not always possible in a stagnant economy with low consumer spending.
Reduced consumer spending: High inflation reduces consumers’ purchasing power, causing them to cut back on spending, especially on non-essential goods and services. This reduction in demand can lead to lower sales volumes for businesses, further impacting their profitability and ability to invest in growth or innovation.
Difficulty with strategic planning and investment: The unpredictability associated with stagflation makes it difficult for companies to plan for the future. Investments become riskier and potentially less profitable, leading to reduced capital spending. Businesses may postpone expansion plans or new ventures until economic conditions stabilize, further slowing overall economic growth.
Impact on Employment: Faced with higher costs and lower profits, companies may resort to reducing their workforce in order to maintain financial stability. This leads to higher unemployment, which is a hallmark of stagflation. In addition, high unemployment contributes to lower consumer confidence and spending, reinforcing the cycle of economic stagnation.
Shift in Business Strategies: In response to stagflation, companies may need to adjust their strategies. This could include focusing on cost-cutting measures, improving operational efficiency, or shifting to products and services that are less sensitive to economic downturns. Diversifying supply chains and markets can also help companies reduce the impact of local economic issues. But they could also sacrifice investment in new technologies, leading to reduced long-term competitiveness. (Article on that: How companies invest well in times of crisis)
Shifting Industry Dynamics: Prolonged periods of stagflation can lead to significant shifts in industry structure. Some sectors could face long-term decline if they fail to adapt to changing economic circumstances, while others that are innovative and efficient could emerge stronger.

Global implications – Different impacts across countries

At a more global level, stagflation can affect different economies in different ways, largely influenced by each country’s specific economic structure, policy framework, and exposure to global markets. Let’s break this down:

Developed vs. Emerging Economies

Developed economies: Typically have more resources to cope with economic shocks, but may face labor market rigidities and higher wage expectations that exacerbate stagflation. However, these shocks tend to be more manageable as they can be mitigated in the medium term due to the relative attractiveness of these markets.
Developing economies: Often more vulnerable to external shocks, especially if they are heavily dependent on imported goods or foreign capital, and their relative vulnerability is higher because imports may be a higher percentage of total costs than in other countries. It is also worth noting that stagflation can have a severe impact on poverty levels and overall economic development.

Export-oriented vs. import-dependent countries

Export-oriented countries: May temporarily benefit from higher global prices for their exports, but may suffer in the long run if global demand falls due to a global economic slowdown. This needs to be managed but the extra incomes can help to support other policies.
Import-dependent countries: Particularly vulnerable to stagflation, especially if they rely on imports for essential goods such as food and energy, leading to a faster and more intense impact of global price increases while at the same time suffering more from a slowing economy.

Diversified vs. Specialized Economies

Diverse economies: Better equipped to deal with the effects of stagflation because they can more easily pivot between sectors, mitigating the risks associated with specific industries.
Specialized economies: More vulnerable during stagflation, especially if they specialize in sectors that are hit hard by rising costs or falling demand (e.g., energy-intensive industries during an oil shock).

Political and Economic Alliances

Countries in economic unions: Can use collective bargaining and shared resources to better manage the effects of stagflation, although policy coordination can be challenging.
Isolated countries: May have fewer options for external support and more difficulty accessing international financial markets, exacerbating economic distress.

Currency Strength and Exchange Rate Dynamics

Strong currency nations: May find imports cheaper, which may alleviate some inflationary pressures, but may also face reduced competitiveness in export markets. This is what happened in Switzerland during the 2023 inflation and during COVID.
Weak Currency Nations: Suffer more from imported inflation and may see a rapid deterioration in trade balances, which can exacerbate stagflation.

Technological Sophistication and Adaptability

Technologically Advanced Countries: They are often better equipped to adopt efficiency-enhancing technologies that can help counteract the effects of stagflation by reducing production costs and increasing productivity. The more technologically advanced a country is, the less dependent its labor force is on other resource inputs, making it more resilient.
Less technologically advanced countries: May struggle more with stagflation because they cannot quickly adapt to changing economic conditions through technological solutions and also several technologies are not so dependent on external prices. E.g. an IT firm is less impacted by soaring energy prices than a steel manufacturing company which is dependent on predictable energy prices.

Dependence on commodity prices

Commodity-exporting countries: Fluctuations in global commodity prices can dramatically affect the economic stability of these countries. High prices can provide a windfall, but also risk creating an over-dependence that can hurt when prices normalize and create a shock afterwards.
Commodity-importing countries: Face increased vulnerability to global supply shocks that cause prices to spike, feeding directly into stagflationary pressures.

Labor Market Flexibility

Flexible labor markets: Can more easily adjust to economic shocks by reallocating labor to more productive sectors, potentially mitigating some of the effects of stagflation. While this may hurt in the short term as unemployment is higher and more people lose their jobs, it may also be beneficial in that the economy adjusts faster and firms can act more quickly.
Rigid labor markets: Can exacerbate the effects of stagflation, with high unemployment and inefficiencies preventing a rapid recovery. In particular, if firms are unable to adjust their workforce quickly, it can also become a problem for firms in the short run, limiting their recovery in the long run.

Social and Political Stability

Stable Societies: Generally better at enacting and maintaining coherent economic policies, which can be critical to effectively managing stagflation.
Politically or socially unstable regions: May experience exacerbated economic challenges during stagflation, as instability can deter investment and hinder effective government response.

Integration with global financial markets

Highly integrated economies: Have greater access to international capital, which can provide liquidity in difficult times but also increases exposure to global financial shocks.
Less integrated economies: Although somewhat insulated from global financial turmoil, they may lack the financial mechanisms to cushion the economy against stagflation. We have seen that already during Covid as an example.

Comparing Stagflation vs. Recession vs. Depression

Many fear a recession, but stagflation is in many ways worse than a recession. There is also an article on “Recession vs. Depression” if you are interested in this distinction. This chart should help you understand the differences:

Aspect	Stagflation	Recession	Depression
Definition	Simultaneous occurrence of stagnant economic growth, high unemployment, and persistent inflation.	Significant and prolonged decline in economic activity across the economy.	An extreme, prolonged downturn in economic activity, with a substantial decline in GDP.
Primary Economic Indicators	Stagnant or negative GDP growth with rising CPI (Consumer Price Index).	Declining GDP and often a decrease in CPI.	Severe decline in GDP, with persistent high unemployment and widespread deflation.
Impact on Employment	High unemployment persists alongside inflation, complicating livelihoods and economic stability.	Unemployment increases as businesses cut back or close, with potential wage deflation.	Extremely high unemployment rates; long-term joblessness becomes common.
Inflation Dynamics	Inflation remains high despite reduced consumer spending, driven by cost-push factors.	Inflation rates typically decrease, sometimes leading to deflation as demand falls.	Prolonged deflation as demand plummets far below supply capabilities.
Monetary Policy Challenges	Tricky balance required: Lowering interest rates may worsen inflation, while raising rates can further depress economic activity.	More straightforward: Lowering interest rates generally encourages spending and investment.	Interest rates often already near zero; monetary policy may have limited effects without significant government intervention.
Fiscal Policy Challenges	Needs carefully crafted policies to curb inflation without suppressing growth; may involve targeted subsidies or tax adjustments.	Fiscal stimulus (e.g., spending increases, tax cuts) aimed at boosting demand and employment is more directly effective.	Requires massive fiscal intervention, often involving extensive government spending to stimulate demand and restore confidence.
Long-term Economic Strategies	Complex and multifaceted approaches needed to stimulate growth while controlling inflation; often involves structural economic reforms.	Focus on recovery and growth stimulation; typically involves enhancing consumer confidence and restoring investment levels.	Deep, structural economic reforms required; recovery strategies focus on rebuilding the economy and possibly redefining economic policies.
Typical Duration	Can last longer due to the complexity of simultaneous high inflation and unemployment.	Generally shorter, dependent on effective fiscal and monetary interventions.	Longest duration; recovery can take a decade or more, depending on the severity and responses.

Duration of stagflation

Unlike typical economic downturns, stagflations have no “standard duration” and because they are rare in history, we have no reliable information. Historically, periods of stagflation have ranged from a few years to nearly a decade but it is certain that they can vary widely depending on several factors:

Severity of the initial shock: The intensity of the initial supply shock or policy misstep can influence how deeply stagflation becomes embedded in the economy.
Global economic conditions: External conditions, such as global demand and commodity prices, also play a critical role in the duration of stagflation.
Country specifics: As we learned earlier, there are several factors that influence the vulnerability of an individual country or region. This can greatly affect the outcome and duration.
Policy Responses: Effective policy responses can shorten the duration, while inadequate or inappropriate policies can prolong it.

To return to the previous example, the stagflation in the United States in the 1970s lasted about a decade. It was exacerbated by initial policy missteps and persistent oil price volatility, as there were two major shocks.

Strategies for tackling stagflation

The effective resolution of stagflation requires a well-coordinated, I mean REALLY WELL-COORDINATED, approach that includes both monetary and fiscal policy interventions in addition to structural reforms. The problem is that no government acts alone, and especially in today’s world where there is less global cooperation, there could even be a race to the bottom as many governments see the opportunity to grow faster while other economies struggle less. This would be a “I am bad, but its good as long as others are worse” paradigm that would even benefit some regions and countries in the global economic perspective. Some of these include:

1. Monetary policy adjustments

Interest rate strategy: Normally a gradual increase in interest rates helps to curb inflation without shocking the economy. But if there is too much money in the market, faster interest rises might be necessary.
Open Market Operations: Use these to carefully control the money supply by selling government bonds to mop up liquidity when the inflation rate is high.
Currency Stabilization: Stabilize the national currency to avoid exacerbating inflation through import costs, especially in smaller, open economies.

2. Fiscal policy initiatives

Countercyclical spending: Engage in countercyclical fiscal policy to stimulate demand during downturns without increasing inflation during upturns.
Windfall taxes: Implement windfall taxes on companies in sectors that benefit disproportionately during economic shocks (e.g., energy companies during oil price spikes). These taxes could be used to reallocate excess profits to fund public services or provide targeted relief to sectors or demographics most affected by stagflation.
Subsidy adjustments: Rationalize subsidies, especially on commodities, to reduce government spending and redirect resources to more productive uses.
Debt management: Carefully manage public debt to avoid crowding out private investment and maintain fiscal sustainability.

3. Structural reforms

Productivity enhancement: Focus on increasing productivity through investment in education, research and development, which can increase the potential output of the economy, but this is a very long-term investment, rather precautionary against future stagflation.
Competition policies: Implement or strengthen policies that promote competition in key sectors to reduce monopolistic and inflationary pressures. Monopolies and oligopolies may take greater advantage of rising prices to increase their profit margins.
Health and social security reforms: Stagflation or Recessions are a good time to improve health and social security systems. These can reduce the economic burden on the working population and increase disposable income, thereby promoting economic growth, also on the long run.

4. Coordinated global actions

Commodity price stability agreements: Work with other nations to stabilize the prices of critical commodities such as oil and food, which can be significant drivers of inflation.
Financial market regulations: Strengthen global financial market regulations to prevent speculative trading that can exacerbate commodity price shocks and economic volatility.

5. Advanced economic measures

Inflation Targeting: Adopt or refine inflation targeting frameworks to provide clear guidance on inflation expectations, thereby helping to anchor economic forecasts and planning.
Dynamic Tax Policies: Implement dynamic tax policies that can adjust to economic conditions, helping to manage demand without triggering spikes in inflation.
Technology Adoption in Government Services: Use technology to improve the efficiency of government services, reducing costs and improving service delivery, which supports economic stability.
Economic diversification: Especially when existing industries are suffering, it may be a good time to use market pressures to enable entrepreneurs to start new businesses and use innovation as a driver to get out of the situation. While startups and entrepreneurs may take several months and years to create jobs, this also strengthens the underlying economy.

Conclusion

Stagflation is a unique and complex challenge for economies, governments and businesses around the world. It requires a multifaceted and carefully balanced approach to economic policy. The tools and policies I mentioned, ranging from monetary adjustments to fiscal initiatives to structural reforms, highlight the range of options available to address such an economic dilemma but that being said it is that most of these take long and there is no “quick fix” as it is somehow a dilemma. It is crucial that these policies be flexible and responsive. They should allow for adjustments as economic conditions evolve as oversteering could lead to a worsening of the situation.

The past few years, particularly 2023 and 2024, have put immense pressure on global markets, governments and especially central banks. The aftermath of the COVID-19 pandemic saw a surge in government intervention, with economies being stimulated with large injections of cheap money under very loose monetary policies. As the world grapples with the consequences of these actions, particularly the potential for stagflation, the role of central banks becomes increasingly precarious. They face the dual challenge of preventing a recession while avoiding potential stagflation. The situation is further complicated by high inflation rates due to excess liquidity in the market and the economic fallout from the war in Ukraine, which has led to energy price shocks.

Navigating this landscape requires judicious policymaking to avoid “oversteering” that could stifle economic growth or exacerbate inflation. Ongoing interest rate adjustments highlight the delicate balance that central banks have to maintain between addressing growth constraints and moping-up excess money. The road to recovery from the COVID shock and subsequent geopolitical tensions is likely to be long and uncertain. Understanding the dynamics of stagflation and monitoring global economic trends will be essential to designing responses that are both prudent and effective.

Benjamin Talin

Benjamin Talin, a serial entrepreneur since the age of 13, is the founder and CEO of MoreThanDigital, a global initiative providing access to topics of the future. As an influential keynote speaker, he shares insights on innovation, leadership, and entrepreneurship, and has advised governments, EU commissions, and ministries on education, innovation, economic development, and digitalization. With over 400 publications, 200 international keynotes, and numerous awards, Benjamin is dedicated to changing the status quo through technology and innovation. #bethechange Stay tuned for MoreThanDigital Insights - Coming soon!