Stagflation

Stagflation is the combination of stagnant growth (or recession), high unemployment, and persistent inflation. It is a policymaker’s nightmare because the usual remedies conflict: stimulus to fight unemployment worsens inflation; interest rate hikes to fight inflation deepen unemployment. Stagflation typically results from supply shocks that simultaneously reduce output and raise prices.

Why stagflation occurs

Stagflation arises when supply shocks reduce the economy’s productive capacity:

• Oil embargo (1973-74): OPEC cut oil supplies → energy prices spiked → inflation rose.
• But economy had less oil: Production fell, layoffs occurred → unemployment rose.
• Result: Inflation and unemployment both high — defying the normal Phillips curve trade-off.

Other supply shocks that can trigger stagflation:

• Pandemic shutdowns (2020, briefly).
• Major crop failures causing food price spikes.
• Geopolitical disruptions (wars, embargoes).
• Technological disruption causing worker displacement without offsetting new job creation.

The Phillips curve breakdown

Pre-1970s, the Phillips curve suggested a stable trade-off: low unemployment ↔ high inflation.

Stagflation broke this relationship:

• 1969: Unemployment 3.5%, inflation 5.5% (on the curve).
• 1975: Unemployment 8.5%, inflation 9% (off the curve; both high).

This shocked policymakers, who had no framework for stagflation. It led to the “expectations-augmented Phillips curve” (inflation depends on expected inflation + unemployment gap + shocks) — much more sophisticated.

Policy dilemmas

Stagflation traps policymakers:

Stimulus approach (fight unemployment):

• Cut interest rates, boost spending.
• Reduces unemployment, but prices rise faster.
• Inflation becomes entrenched (worse inflation expectations).
• 1970s experience: Stimulus made stagflation worse.

Tightening approach (fight inflation):

• Raise interest rates, reduce demand.
• Reduces inflation, but unemployment spikes further.
• Severe recession required.
• Volcker’s approach: Brutal but broke inflation.

There is no good option. This is why stagflation is so feared.

The 1970s stagflation

The classic case:

Causes:

• 1973 oil embargo: Oil quadrupled to $12/barrel (extreme shock in 1970s dollars).
• Policy mistakes: Fed eased in 1971-72 (inflationary).
• Inflation expectations rose after earlier inflation; wage-price spiral emerged.

Outcome:

• Inflation rose from 3% (1970) to 14% (1980).
• Unemployment rose from 4% to 9%.
• Real wages fell (stagflation’s hallmark).
• Real stock returns were negative for a decade (S&P 500 fell in real terms 1970-82).

Resolution:

• Volcker became Fed Chair (1979), immediately tightened.
• Interest rates soared to 20%; severe recession (1981-82).
• By 1983, inflation was back to 3%.
• Cost: Unemployment hit 10.8% and stayed elevated 1982-85.

The 1970s weren’t unique

Economists note stagflation episodes in:

• 1950s: Post-Korean War inflation combined with weak growth.
• 2022: Brief stagflation as COVID supply shocks hit and demand remained strong. But it was short-lived as supply recovered.

True prolonged stagflation (like 1970s) is rare.

Defending against stagflation

Policymakers learned from the 1970s:

1. Anchor inflation expectations. If workers and firms believe inflation will be 2%, they do not demand outsized wage hikes when supply shocks occur. This prevents wage-price spirals.

2. Accept some initial unemployment rise. When supply shocks hit, painful adjustment is inevitable. The key is not to let inflation expectations unanchor.

3. Credible central bank. If the central bank has a track record of maintaining low inflation, workers accept that high inflation is temporary and do not demand future wage hikes.

Post-2022, the Fed acted quickly to raise interest rates when inflation spiked, and inflation expectations remained anchored (despite the shock). This prevented 1970s-style stagflation.

2022: A brief stagflation scare

When oil spiked and inflation surged in 2022, some economists warned of stagflation. The situation:

• Inflation rose to 9% (headline).
• Growth slowed; some feared recession.
• Unemployment remained low.

But it was not true stagflation because:

• Supply shocks were easing (supply chains recovering, oil prices moderating).
• Inflation expectations stayed anchored (markets expected Fed would tighten).
• Growth never turned negative (avoided recession).

By late 2023, inflation had fallen sharply while growth rebounded. Stagflation avoided.

Stagflation and asset returns

Stagflation is devastating for investors:

• Stocks fall: Declining earnings (low growth) + rising discount rates (inflation premium).
• Bonds fall: Rising interest rates + rising inflation.
• Currencies weaken: Capital flight as real returns deteriorate.
• Gold soars: Inflation hedge; only asset that works.

The 1970s saw nominal stock returns near zero and real returns deeply negative — a lost decade.

See also