Inflation vs. Stagflation: An Overview
Inflation is the broad rise in the price of goods and services across the economy. The Federal Reserve deems annual inflation averaging 2% over the long run most consistent with its mandates of stable prices and maximum employment because that keeps the much more dangerous deflation at bay while supporting economic growth. Still, inflation causes a currency to lose purchasing power. For example, if inflation is at 5% and you currently spend $100 per week on food, the following year you would need to spend $105 for the same groceries.
Typically, inflation goes hand-in-hand with economic growth, and an overheated economy is one possible cause of higher inflation. Conversely, recessions typically cause inflation to slow. The relationship is intuitive. In an economy running hot by operating above its long-term potential, price increases are necessary to ration labor and other scarce inputs and to offset those increased production costs. Meanwhile, a contracting economy with lots of spare capacity restrains price hikes and wage increases as demand slows.
Stagflation is a term used to describe a stagnant economy hampered not only by slow growth but by high inflation as well. While this combination may seem counterintuitive, it proved real during the 1970s and early 1980s when workers in the U.S. and Europe were subjected to high unemployment as well as the loss of purchasing power.
The causes of stagflation during that period remain in dispute, as did the likelihood of a reprise in 2022 amid high energy and food prices, rising interest rates, and persistent supply-chain snags.
Key Takeaways
- Inflation is the rate of increase in the overall price level of goods and services in an economy.
- Stagflation describes a combination of high inflation and economic stagnation as reflected by a slow growth rate and high unemployment.
- The stagflation of the 1970s marked the U.S. economy's worst performance since the Great Depression.
- The causes of stagflation remain contentious, with some blaming loose fiscal and monetary policies and others austerity or oil price shocks.
Inflation
As noted above, central banks like the Federal Reserve, often referred to as the Fed, and the European Central Bank (ECB) prefer modest inflation to none at all, as insurance against destabilizing deflation. Policymakers aim for inflation of 2% to grease the wheels of commerce.
They also seek to understand what's causing inflation, because inflationary impulses come in several distinct types, each with its own cause and consequences. Three key varieties are demand-pull inflation, cost-push inflation, and wage-price spiral inflation, the latter also known as built-in inflation.
Demand-pull inflation happens when demand for goods and services rises above the economy's capacity to meet it.The law of supply and demand suggests demand will moderate in that case only in response to higher prices. Demand-pull inflation can result from loose fiscal and monetary policies or from inadequate investment. In all those cases, monetary and fiscal tightening is the likely outcome, since investments in increasing the economy's productive capacity often take a long time to produce results.
Cost-push inflation reflects a rise in prices of one or more key economic inputs, such as crude oil, grain, or labor. Cost-push inflation results when producers are able to recoup their increased costs by increasing the price of finished products. If input costs rise as a result of a temporary disruption in supply such as factory closings caused by a pandemic, for example, policymakers may reasonably assume the price pressures will prove temporary as well.
Cost-push inflation occurred in 2005 after Hurricane Katrina destroyed gasoline supply lines in the region. The demand for gas did not change but the lack of supply raised the price of gasoline to $5 a gallon.
The wage-price spiral, sometimes also called wage-push inflation or built-in inflation, describes instances when rising wages and prices reinforce each other, with higher prices driving wage increases which then result in still higher prices. The wage-price spiral is what can happen when policymakers fail to bring inflation under control.
A wage-price spiral seemed improbable for decades after Paul Volcker's Fed tamed inflation in the early 1980s, bringing stagflation to an end. In the aftermath of the 2007 to 2008 Great Recession and financial crisis and until 2021, inflation mostly fell short of the Fed's targets amid lackluster economic growth.
Inflation is a singular phenomenon that can have multiple causes and many inflationary episodes don't fit neatly into one of the categories above. For example, the increase in inflation in 2021 and 2022 reflected the demand-pull effect of the fiscal stimulus in U.S. pandemic relief legislation, as well as the cost-push of supply chain disruptions, including sharply higher shipping costs. The inflation of the 1970s has been variously attributed to the cost-push of oil price shocks and the demand-pull of relaxed fiscal and monetary policies.
Stagflation
The debate about what caused stagflation in the 1970s features a similar list of prime suspects, from soaring energy prices to the end of managed exchange rates following the collapse of the Bretton Woods system.
Accounts blaming the toxic combination of weak growth and high inflation on policymakers' insufficient fiscal and monetary discipline have been countered by others highlighting the effects of fiscal austerity and the abandonment of administrative and informal price and wage restraints.
What's indisputable is that it took a pair of painful recessions to bring down inflation for good and legislation enacting larger U.S. budget deficits and economic deregulation to revive growth during Ronald Reagan's presidency.
Stagflation marked the worst performance by advanced economies between the Great Depression and the Great Recession, and as such left a lasting mark. It led economist Arthur Okun to come up with a misery index summing the inflation and unemployment rates, and the name encapsulates how that period of economic history is remembered.
One obstacle in the way of a stagflationary re-rerun is the modern global economy's significantly reduced dependence on energy to generate growth. Others include the historically large U.S. budget deficit, interest-rate increases by the Federal Reserve, and modest inflation expectations shaped by decades of low inflation.
The old argument about whether inflation stems from too little regulation or too much has returned in a new guise, as a debate about whether companies' increased market concentration has allowed them to raise prices, contributing to recent inflation.
The Bottom Line
The only difference between inflation and stagflation is economic growth. Typically, inflation is coupled with economic growth and can even be a byproduct of a rapidly expanding economy. Conversely, recessions usually slow inflation. Stagflation refers to the rare and puzzling phenomenon of a recession coinciding with prolonged high inflation.
Economic conditions in early 2022 led many commentators to wonder whether the U.S. was headed for a return to stagflation. However, most analysts believe the country's reduced reliance on imported oil—and energy, in general—plus the Federal Reserve's credibility should stave off 1970s-style stagflation.
Why Is Stagflation So Unpopular?
The combination of slow growth and inflation is unusual because inflation typically rises and falls with the pace of growth. The high inflation leaves less scope for policymakers to address growth shortfalls with lower interest rates and higher public spending.
What Is the Misery Index?
The misery index is the sum of the unemployment and inflationrates. It was popularized in the 1970s as a rough measure of the economic distress amid stagflation.
What Is Purchasing Power?
Purchasing power measures the value of a currency in terms of the goods and services a unit of that currency can buy. Inflationdecreases the number of goods or services you can purchase for a set amount of money, lowering purchasing power.
