Stagflation is a word that has started to fill the news wires a lot recently.
The media space is full of warnings from economists and multilateral financial institutions warning of the dangers of this phenomenon. The casual reader and observer of the news would be at a loss to explain this economic concept and how it would affect them. Most casual readers and observers of the news would be at a loss to explain in lay terms any economic concept even if their lives depended on it.
- Stagflation refers to an economic phenomenon where a country’s GDP shrinks while inflation rises.
- This economic concept has become highly topical in both advanced and emerging market economies, especially now that prices increase and lower productivity.
- Economic growth is slowing because of sharply increasing energy and food prices. These themes are what has come to characterize the global economy.
As far back as June 2022, leading media outlets began to report the possibility of the global economy heading for slower growth, rising prices, and high unemployment. The Washington Post called this “a toxic brew that could hamper the economic recovery of countries from the COVID pandemic.”
Soon after that, the World Bank warned that those forces (slower growth, rising prices, and high unemployment) called “stagflation could induce years’ worth of struggles. This warning from the multilateral institution implied that the impact of this economic beast called stagflation could be felt for years to come if it is allowed to continue unchecked.
The last notable period of stagflation in the global economy was in the 1970s, when oil prices increased to some of their highest levels on record at the time. In today’s context, stagflation emanates from persistent problems like supply chain snags, Russia’s attack on Ukraine, and the recurring waves of COVID and the response of countries to them.
What is stagflation?
There are several definitions and descriptions of this concept. Universally it is agreed that the term stagflation is a mash-up of two words, “stagnation” and “inflation”. What is also universally agreed is that this concept describes a malfunctioning economy characterized by soaring inflation while economic growth — the rate of increase in the output of goods and services — slumps.
- When a labour market is too rigid or when energy prices increase too sharply, they can lead to stagflation in an economy.
- The economic concept of stagflation concept from a combination of two words, “stagnation” and “inflation”.
- Central banks the world over have resorted to dealing with inflation headwinds by increasing interest rates.
- In an environment with stagflation, interest rates can be a blunt instrument to consumers by curtailing their ability to consume, a problem already compounded by rising inflation.
The lack of economic growth over time can lead to higher unemployment. Economists proceed to describe this concept as a period where real incomes fall as wages struggle to keep up with rising prices. During periods of stagflation, households and businesses express concern that the stagflation will continue over the long haul to the extent that it becomes a vicious cycle or self-fulfilling prophecy because it causes them to behave in a way that perpetuates the trend of rising inflation.
This is a mouthful; however, an example would be to say if inflation emerges in an economy from a spike in the price of essential inputs like energy and food, the producers of these will naturally desire to pass these on to the end consumer in the form of higher prices. This creates inflationary pressure because the increase in prices is not met with a commensurate increase in the wages of consumers.
When prices increase, households consume or spend less than they would in normal circumstances, implying that businesses produce less than they otherwise would. Because businesses experience reduced productivity, they then employ fewer people. This vicious cycle can continue in perpetuity unless it is met with a significant supply-side intervention.
Origins of stagflation
The explanation given preempts the origins and source of stagflation. It is usually caused by a rise in the price of commodities like oil, as was the case in the 1970s when the phrase was first coined. In the 1970s, the price of oil reportedly tripled. This current bout of stagflation has been caused by what economists describe as a supply-side shock.
This is because the rise in energy prices generally causes prices to go up, leading to inflation and slow economic growth. The state of the labour market can bring about country-level stagflation. Suppose the labour market is highly unionized and the unions are powerful to the extent that they can bargain for higher wages even in a low economic growth environment. In that case, the result can be inflationary while causing economic stagnation at the same time.
- Monetary policy in an economic environment with stagflation can effectively deal with inflation, but it will not be sufficient to deal with the recession.
- Effective mitigation measures against stagflation include but are not limited to supply-side intervention by governments like the case of Germany, which has taken the lead in Europe by announcing a EUR 65 billion plan to support consumers ahead of the winter.
- The current economic stagflation has been caused largely by geopolitical tension between Russia and Ukraine.
Other reasons that can best explain the origins of stagflation include falling productivity when an economy experience falling productivity. This could be because workers becoming less efficient. The consequence of this will be falling productivity and rising costs. Structural unemployment is another cause in cases where there is a decline in traditional industries.
This creates a tendency for unemployment to rise while productivity falls. Zimbabwe, during its lost decade from 2000 to 2010, experienced this kind of stagflation.
More generally and more contextually, stagflation comes from supply shocks. These result from supply chain disruptions. Where demand for goods and services increases or is unchanged, the result is rising prices and lower productivity.
Stagflation is not desirable in an economy because citizens of a country are generally happy when prices are low and the economy is booming. The opposite is true when prices are rising, the economy is performing poorly, and the prospect of citizens losing their jobs is high. A poorly performing economy can also lead to social unrest if it is left unchecked for a prolonged period. Therefore, stagflation is a risk.
Mitigating the impact of stagflation on an economy is the responsibility of central bankers. Monetary policy can generally try to reduce inflation (higher interest rates) or increase economic growth (cut interest rates). Monetary policy cannot solve both inflation and recession at the same time. One solution to make the economy less vulnerable to stagflation is to reduce the economy’s dependency on oil.
Rising oil prices are the major cause of stagflation. The only real solution is supply-side policies to increase productivity, which enable higher growth without inflation.