Stagflation: What Is It, and Is It on the Horizon?

Stagflation defined

Stagflation defines a period of stagnation, usually in the form of low to negative economic growth, as typically measured by GDP, that occurs at the same time as high inflation, usually measured by the Consumer Price Index (CPI).

Periods of stagflation are rare, as inflation typically escalates when the economy is expanding and unemployment is low. In these times, people have jobs and money in their pockets to spend, which pushes up prices. In contrast, in a recessionary environment of slow growth, lower demand for goods and services and higher unemployment would usually send prices lower.

A flashback to the 1970s

The most notoriously stagflationary environment in the United States in recent history occurred in the 1970s and early 1980s. At that time, several factors contributed to a sluggish, long-term recessionary economic environment and high inflation. Spikes in crude oil prices resulted from the Arab oil embargo of 1973 and the Iran oil embargo of 1979. Those oil shocks, along with the so-called “guns-and-butter” fiscal spending programs on Vietnam and social programs, led to inflationary price increases across the U.S. economy as well as a rise in unemployment. As shown in the graph below, during the 1970s, the blue line representing the unemployment rate bounced around but rose from 3.9 percent in early 1970 to 9 percent in 1975 and as high as 10.8 percent in 1982.

Inflation also climbed during much of the 1970s and reached a peak of 13.9 percent in 1980, despite price controls put in place by the Nixon administration between 1971 and 1974 that were only temporarily effective. During much of the 1970s, the Federal Reserve (the Fed) had emphasized maintaining full employment over controlling inflation, so while interest rates rose in the decade, they did not rise enough to diminish inflation.

It took Fed Chair Paul Volcker’s drastic move in the early 1980s to hike the federal funds rate to 20 percent to finally get inflation to decline meaningfully. Volcker’s rate increases crushed inflation (which fell to 3 percent by 1983), but they led to considerable economic pain, including two recessions in the early 1980s.

U.S. CPI v. Unemployment, January 1970–January 1986

Source: Bureau of Labor Statistics 

Are we in for a similar stagflationary environment?

Once again, we are facing a set of circumstances that could lead to stagflation. Inflation, as measured by the CPI, has risen dramatically in recent months, hitting 9.0 percent year over year in June and, most recently, 7.7 percent in October. While inflation fell back somewhat as gas prices have cooled from their highs, prices are overall much higher than they had been since we saw stagflation in the early 1980s.

U.S. Consumer Price Inflation

*Core CPI refers to the change in prices paid by urban consumers for a group of goods and services. It does not include food and energy prices.
Source: Bureau of Labor Statistics

Inflation has surged for a few reasons, including supply shocks (which were exacerbated by the Russia/Ukraine conflict and the pandemic), a post-COVID-19 surge in demand for services like dining and travel, and the effect of stimulus programs that began in the pandemic, which gave many people additional cash to spend, at least temporarily.

Meanwhile, growth in the U.S., as measured by GDP, was negative in the first two quarters of 2022, fulfilling the technical definition of an economic recession. (It turned positive in Q3.)

So, with inflation spiking and negative growth, are we in for a stagflationary environment?

The argument for “yes”

There are reasons why we could be in for a stagflationary environment.

First, unemployment is quite likely to rise from its current level. As interest rates have risen and may continue to rise, it is expected that demand will slow and economic activity will deteriorate further. This will likely mean layoffs at some employers (as we are seeing now) and a higher level of unemployment. The Fed has said that it will continue to raise rates to kill inflation, even if it means the unemployment rate increases. Unfortunately, interest rates are a fairly blunt tool, and in its zeal to get inflation under control, it is quite possible that the Fed may overshoot and damage the economy. A scenario like this would likely mean a significant uptick in unemployment. If unemployment rises meaningfully before inflation is lower, it could create a stagflationary environment.

While Fed rate hikes are designed to knock down inflation, geopolitical risks to supply and energy are not in the Fed’s purview, as rate hikes only address the demand side of the inflation issue. Further, the Fed is attempting to reduce wage inflation by slowing demand in the economy, which could provide relief to the current tight labor market. However, if workers expect higher wages to compensate for higher inflation, and get them, spending may not cool down. 

The argument for “no”

One reason why we’re not experiencing stagflation now is because the unemployment rate remains historically low as businesses respond to continued strong demand. Unemployment was 3.5 percent in September, a more than 50-year low, as employers in many sectors still find it difficult to find labor to fill job openings. While unemployment increased to 3.7 percent in October and remained at that rate in November, it is still very low relative to history.

Another reason the U.S. may avoid stagflation is that, unlike in the 1970s, the Fed is aggressively taking action early by aggressively hiking interest rates with the mission of drastically reducing inflation. Federal Reserve Chairman Jerome Powell has said that the Fed would accept a recession and/or higher unemployment as a price for curtailing inflation with its rate increases. In a speech given at the Fed’s August retreat in Jackson Hole, Powell cited Volcker’s moves back in 1980 as what is driving the Fed’s decisions today. If the Fed succeeds in tamping down inflation relatively quickly, it may be possible to avoid a stagflationary environment. Finally, while energy was a significant contributor to inflation in the 1970s, the United States is now energy independent, (with the wild card the continuing war in the Ukraine).

Consumers right now may not be expecting inflation to remain this high, though these expectations are in flux month to month, according to the monthly New York Fed survey of consumer expectations. That is important as inflation can become a self-fulfilling prophecy — if people think prices will increase in the future, they are more likely to make purchases at any price today, thus causing prices to remain elevated or even rise. A study of inflation expectations by the New York Fed shows that one and three-year inflation expectations declined significantly in August. However, while one-year inflation expectations declined again in September, three- and five-year expectations rose.

We must wait and see on stagflation

Forecasting inflation is difficult at best, given the many crosscurrents that can play into today’s economic backdrop. Inflation numbers in September surprised to the upside, reinforcing potential for stagflation, but October was the reverse. Understand all these numbers are lagging indicators and there is little clarity on the trend as of now. If the Fed is successful in effectuating a soft landing it will be because consumer resilience provides a foundation for growth, albeit slower, going forward.