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What is stagflation, explained — and why the crisis could return for the first time in 40 years

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Consumers, investors and economists alike aren’t just worried about inflation this year — but also that growth could slow and unemployment could climb along with it.

Together, those three economic enemies combine to form a major supervillain that hasn’t made its way into the American lexicon since the 1970s and ‘80s: stagflation.

Former Fed Chair Ben Bernanke said in a May 16 interview with The New York Times that the economy could face stagflation this year, as prices rise at the fastest pace in four decades and the Federal Reserve ramps up plans to aggressively hike interest rates — what could be 2.75 percentage points alone just this year. Experts say some may be feeling the pinch of stagflation already.

“It might already be the case that some individuals and households feel like they’re experiencing something akin to stagflation right now if they’re not seeing income or wage gains sufficient to keep pace with rising prices,” says Mark Hamrick, Bankrate senior economic analyst.

But the concept is complicated, and not all inflation leads to stagflation. It’s also a mysterious condition in itself, defying how economists think the financial system usually works. Here’s what you need to know about stagflation, including how it works and how you can prepare for it.

What is stagflation?

Stagflation happens when growth slows, demand falters, unemployment rises — and almost contradictorily, inflation keeps climbing.

That’s out of the ordinary because joblessness doesn’t typically bode well for growth, and when demand takes a nosedive, so can inflation. Businesses likely push back investments; consumers are either spending less or have limited amounts of money to fund their purchases. Such concepts are at the heart of the popular theory known as the “Phillips curve,” which suggests that as unemployment falls, inflation should rise, and vice versa.

But not in a stagflationary environment. Joblessness and inflation were both on the rise at similar points throughout the ‘70s and ‘80s, the last time experts say the economy faced a bout of stagflation. On a chart, their peaks and valleys often follow the same progression.

In May 1975, joblessness peaked at 9 percent. Just six months earlier, price increases peaked at 12.2 percent in November 1974. Both would remain elevated until the early ‘80s, when the Federal Reserve essentially manufactured a recession and intervened by raising interest rates.

“Stagflation is sort of the worst of both worlds,” says John Leer, chief economist for Morning Consult, a global intelligence company. “You get elevated inflation combined with no growth, a period of time where incomes are not growing as fast as prices, spending patterns dramatically slow down, businesses stop investing. And all the while you see elevated inflation continuing to erode the real, inflation-adjusted economic output.”

What causes stagflation?

Very specific ingredients go into this recipe for disaster, and a prominent one likely sounds familiar given what’s happening in light of the coronavirus pandemic and Russia’s invasion of Ukraine — supply shocks.

At their basic nature, supply disruptions are stagflationary. If a fast-spreading strain of the bird flu affects a substantial portion of the chicken population, for example, that shortage could raise prices on eggs and meat just as much as it could reduce production and weigh on employment. That’s been the case with today’s semiconductor chip shortages, which have pushed up car prices because they’ve limited production.

Supply shocks were another feature of the ‘70s, when an oil shortage prompted by an embargo abroad caused prices to nearly quadruple.

“People often go back and start looking at what happened in the 1970s with the oil crisis,” Leer says. “Supply-side shocks drive prices up but at the same time prevent continued economic growth.”

What’s dangerous about those kinds of spikes, however, is that they can go on to affect other corners of the economy. When oil is more expensive, it not only becomes costlier to heat up homes or fill up cars with gasoline. Goods and services that require a lot of energy can also get more expensive. Supermarkets can pass along higher shipping costs; taxi services can add gasoline surcharges. All of that highlights the stickier nature of inflation.

But high inflation alone isn’t enough to cause stagflation, experts say. A large part of why is because price pressures left to their own devices can often be self-correcting. They can inspire consumers to pull back on purchases.

“As the saying goes, the cure for high prices is high prices, and demand will likely adjust over time,” Hamrick says.

That’s where other forces come into play to create the perfect storm, one of which is price instability. Even if inflation is high, businesses might be able to better strategize how to eat those costs if they knew where they were heading. If inflation jumps around, however, that planning can be challenging.

In 1973, for example, consumer prices rose by an average 3.3 percent. By 1974, however, they averaged 11 percent and sank to 5.8 percent in 1976 — only to again climb to 13.5 percent in 1980.

Making matters worse, consumers and businesses notice when inflation is unstable. The longer it goes on, the bigger the risk that they see it as a facet of American life. Economists have long argued that expectations for higher inflation can be a self-fulfilling prophecy. Workers can ask for higher pay; businesses and consumers might front-load many of their big-ticket purchases with the fear that prices will only keep going up.

An important intermediary is the Federal Reserve. By acting tough with monetary policy and committing to cooling inflation, officials can extinguish the flame before it becomes a larger forest fire.

But Fed historians argue the Fed wasn’t tough enough in the ‘70s and ‘80s. Too-loose monetary policy contributed to the high inflation levels of the era, they say — not just because low rates kept fueling growth but also because it made Fed watchers question whether officials were truly serious about bringing inflation back down.

“It does depend on the credibility of the central banks,” Morning Consult’s Leer says. “We see mixed signals from financial markets, and our high-frequency data continues to show growing inflation expectations, so that’s fairly concerning.”

Is stagflation going to happen?

The Fed’s hawkish pivot will be key to keeping history from repeating itself. Fed Chair Jerome Powell said in a May public appearance that there “won’t be any hesitation” at the U.S. central bank to keep hiking interest rates until inflation falls.

Officials have tightened financial conditions simply by saying they’re going to keep raising rates. The 10-year Treasury yield so far this year is up 2.36 percentage points from its all-time low in August 2020. Mortgage rates have followed suit, with the average rate on a 30-year fixed mortgage rising to a 13-year high in May.

Investors and consumers also see inflation holding higher than the Fed’s 2 percent target in the years ahead but not as high as today’s levels, according to three key gauges tracking inflation expectations.

Yet, noticing stagflation could also be difficult at a time when just 3.6 percent are unemployed, near a half-century low. Powell has described today’s job market as tight “to an almost unhealthy level.” That might mean some uptick in joblessness is inevitable as the Fed starts to raise interest rates.

But if joblessness rises 0.5 percentage points, it will have fulfilled a long-running economic theory that signifies when the economy is in a recession, known as the “Sahm rule.” Even so, a 4 percent unemployment rate would still be among the lowest rate since the late ‘60s.

“There won’t be an economic litmus test per se to measure whether stagflation is occurring,” Hamrick says. “Another way of looking at it could be that there could or would be differing degrees or flavors of stagflation.”

Yet, that doesn’t mean the U.S. economy will be free from slowing growth. Experts have long forecasted that the financial system would hit a fiscal cliff this year as the economy’s stimulus-driven sugar high wears off. Growth in the first three months of 2022 also contracted 1.4 percent, though experts have attributed the decline to trade deficits.

All of that sets the financial system up on an unfortunate reality, one where growth was already set to slow drastically long before officials started taking their feet off the gas pedal. The S&P 500 approached bear market territory during Friday trading, meaning the index plunged nearly 20 percent from its record high, largely on recession fears as inflation rises and the Fed charts forward with rate tightening.

“It feels premature to say we will definitely be there, but I do think that’s the right mental model for the next 12 months or so,” Leer says, referring to stagflation. “You’re likely to see slower economic growth, and it’s going to take some time for inflation to come down.”

4 ways to prepare for possible stagflation

Whether or not the experts want to call it stagflation, that debate might not matter for your wallet. Periods of high inflation, reduced demand for workers and slowing growth can hurt your money, and preparing is the best way to protect your money.

1. Take advantage of today’s strong job market while you still can: 

Even with the prospect of growth slowing, businesses still have a historic amount of demand for workers. Take advantage of that power by negotiating for a raise or hunting for a new position. Data suggests that job switchers see bigger pay gains.

2. Craft a budget

High inflation makes it all the more crucial to evaluate where your money is going each month. Take a careful look at your finances, track your spending and compare that with where prices are rising the most. Having an understanding of your own personal inflation rate can help you avoid purchasing items that are inflated, freeing up crucial amounts of cash.

3. Plan for emergencies

Use that freed up cash to start adding to an emergency fund. Experts typically recommend building up an ample cushion of cash worth at least six months’ of your expenses, though any little bit could help in a period of joblessness. Don’t be afraid to start small and automate your savings.

4. Think about your bear-market strategy

No investor likes to stomach losses — especially if that money is going toward your retirement or a long-term goal. But in times of severe market volatility, it’s important to avoid overreactions. Avoid the urge to sell it off, diversify your investments and remember that the average bear market lasts around 15 months, according to the Schwab Center for Financial Research.

Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Senior wealth editor