Stagflation happens when an economy shrinks or suffers very low growth while prices still continue to rise.
On their own, falling growth or surging inflation would be enough to make households worse off. The two together can be particularly unpleasant and hard for governments to bring under control. With inflation rates on the rise around the world and many rich countries still recovering from recession, some analysts believe countries are going through stagflation now.
There is no single set of circumstances that indicates stagflation. But the most cited example is the 1970s when oil prices rose sharply, depressing growth and fuelling inflation and unemployment. The United States, for example, saw inflation hit 14%, growth contract in both 1973 and 1974 and the unemployment rate jump from 5% to 9%.
According to the OECD, a think-tank for the 34 richest countries, the annual inflation rate in Europe rose from 2.2% to 2.8% in the year to January 2011. In the UK it is 4.0%. Economies are growing after the recession of 2009 but growth in Japan and the UK contracted in the last quarter of 2010. On that basis stagflation is not as severe as the 1970s. Some are calling the current experience “stagflation-lite”.
Horns of a (stag-flation) dilemma
Stagflation creates a painful dilemma for central banks. Weak growth normally brings inflation down. Central banks use interest rates rise to quell high inflation but when the economy is already weak, this creates the risk of a recession. Decision-makers at the Bank of England and the European Central Bank have hinted they may raise rates soon, although the US Federal Reserve seems less likely to act. Some central bankers are worried by what happened in the 1970s when the Fed tried to stimulate growth but, say economists such as Allan Meltzer, only fuelled inflation further. That time, when the Fed did act against inflation it had to raise rates sharply to get inflation back down, triggering a recession.
Households face a pincer movement of falling growth (that may lead to job losses) and high inflation (that cuts their spending power by pushing up shop prices and eats into the value of their savings). The “misery index” is an economic measure that adds together a country’s inflation and unemployment rate. As an eZonomics poll on the misery index points out, the higher the index the more unhappy people tend to be.
Coping with stagflation
Savers facing stagflation can try to protect themselves against inflation. Index-linked investments typically pay an interest rate just above inflation are one method, as this eZonomics article explains. More adventurous investors might try to hedge against inflation via investments related to commodities but the success of such strategies is the topic of debate. Households can also reduce their spending so that a freeze or a cut in wages or even the loss of employment will not come as such a shock.
Clarity Economics’ lead consultant