What is Stagflation?
Stagflation is a term used to describe a specific state of an economy. It is a combination of two words: stagnation and inflation.
For an economy to be experiencing “stagflation”, there are certain criteria that need to be occurring:
- Economic stagnation – this can be described as a period of low (close to zero) growth or negative growth.
- High inflation – when inflation would be considered to be very high, relative to average levels
- High unemployment – where the jobless rate increased significantly above historic lows.
When all of the conditions occur simultaneously, then the economy can be said to be experiencing stagflation.
The origins of Stagflation
The term “stagflation” was first used in the UK Parliament in 1965. However, it was not until the mid-1970s that the oil crisis of 1973 had huge negative economic consequences and stagflation became used more broadly.
As OPEC (which controlled over 50% of the world’s oil supply at the time) embargoed oil supplies, the oil price spiked from $2 per barrel to $11. Gasoline prices in the US soared by 40%, leading to high inflation and unemployment to rise with the US economy shrinking by around -2.5%.
The economic conditions of stagflation were not theoretically possible according to the models of Keynesian economics (such as the Phillips Curve). So when they occurred during the OPEC crisis of the 1970s, it brought about a fundamental shift in economics.
Stagflation in 2023?
So fast forward to the 2020s and the term “stagflation” is being used again. There was a huge monetary and fiscal stimulus of 2020 and 2021 in response to the COVID pandemic. This stoked the fires for an inflation spike in 2022. Combined with the energy price shocks arising from the war in Ukraine, economies around the world have been experiencing high levels of inflation and subsequently economic contraction and recession.
However, for now, the one aspect that is not present is especially high levels of unemployment. In 2023, the question will be whether the highly restrictive interest rates contract economies to the extent that unemployment rates move sharply higher.
When tackling high inflation and an economic slowdown, central bankers will often talk about engineering a “soft landing” (preferable) rather than a “hard landing” (not desirable). If they fail and a hard landing results, the economic contraction may drive high unemployment. If this comes at the same time that inflation remains stubbornly high, then stagflation could be a risk for 2023.
Financial markets during stagflation
Some assets tend to perform well during periods of times of economic strain, such as during stagflation. Here are some that would traditionally be seen as a haven:
- US Treasuries – US bonds are seen as ultra-safe for investors and as a place to park money during times of economic crisis.
- US dollar – The USD tends to be seen as a haven in forex markets
- Gold – The yellow metal is traditionally seen as an asset that performs well during times of economic hardship.
