Stagflation is one of the most complex economic conditions, marked by the rare combination of high inflation, stagnant economic growth and rising unemployment. Unlike typical inflationary periods or recessions, stagflation presents unique challenges that are difficult for policymakers, businesses and investors to navigate. Understanding the causes of stagflation is crucial for identifying warning signs and preparing for its potential impact. While no single factor causes stagflation, a mix of supply-side shocks, demand-side pressures, monetary and fiscal mismanagement and central bank policy choices can contribute to its development.
SUPPLY-SIDE SHOCKS: DISRUPTIONS THAT DRIVE INFLATION
One of the most significant triggers of stagflation is a sudden and severe supply-side shock – an event that disrupts production, increases costs and reduces economic output. When supply-side disruptions coincide with weak economic growth, stagflation can take hold.
Rising commodity prices
A sharp increase in the price of essential commodities – such as oil, natural gas and agricultural products – can be a primary driver of stagflation. Rising input costs for businesses lead to higher consumer prices while also discouraging production and investment, creating an economic slowdown.
The oil shocks of the 1970s were a textbook example. In 1973, the Organization of Arab Petroleum Exporting Countries (OAPEC) imposed an oil embargo on the US and its allies, leading to a fourfold increase in oil prices. This raised energy costs for businesses and consumers, driving inflation while simultaneously reducing economic output. A second oil shock in 1979, caused by the Iranian Revolution, further exacerbated stagflationary pressures.
In today’s world, similar risks exist. The Russia-Ukraine war led to surging oil and gas prices in 2022, affecting inflation worldwide. Supply chain disruptions in commodities such as wheat, fertilizers and rare earth metals also increased global production costs. These types of shocks create conditions ripe for stagflation.
Supply chain disruptions
Global supply chains play a crucial role in modern economies, ensuring the efficient flow of goods and services. However, disruptions – such as natural disasters, pandemics or geopolitical tensions – can cause scarcity of critical materials, delays in production and rising costs.
The Covid-19 pandemic provided a real-world example of supply-driven inflation. Factory shutdowns, shipping bottlenecks and labour shortages increased prices across multiple sectors, from consumer electronics to food products. Meanwhile, economic growth remained fragile, with businesses struggling to recover from prolonged lockdowns.
Geopolitical events and trade restrictions
Geopolitical instability can significantly impact global trade and supply chains, leading to stagflationary pressures. Trade wars, sanctions and military conflicts disrupt the flow of essential goods, increasing costs and limiting production.
For example, the US-China trade war led to higher tariffs on imported goods, increasing costs for manufacturers and consumers. Similarly, sanctions on Russia in response to geopolitical conflicts disrupted energy supplies, pushing European inflation higher. If global trade networks remain strained, stagflation risks could persist.
DEMAND-SIDE FACTORS: THE ROLE OF CONSUMERS, WAGES & BUSINESS INVESTMENT
While supply-side shocks are a key driver of stagflation, weak consumer demand, rising wage pressures and sluggish business investment can reinforce economic stagnation.
Falling consumer confidence and spending
Consumer confidence plays a crucial role in sustaining economic growth. When households feel uncertain about the future – whether due to job insecurity, high inflation or rising borrowing costs – they reduce spending. This weakens demand, slows economic growth and can contribute to stagflation.
During stagflationary periods, purchasing power declines because wages fail to keep pace with inflation. Households struggle to afford essential goods and services, leading to weaker retail sales and lower demand for discretionary products.
The 1970s stagflation crisis saw consumer confidence collapse as inflation soared, causing a drop in real wages. In the UK, the Winter of Discontent (1978-79) was marked by widespread strikes and economic uncertainty, further eroding consumer spending.
Wage-price spirals: When inflation becomes self-reinforcing
In a wage-price spiral, higher prices lead to higher wage demands, which in turn push prices even higher. This cycle can entrench stagflation if businesses pass rising labour costs onto consumers, creating an ongoing loop of inflation without economic growth.
The 1970s saw powerful trade unions negotiate automatic wage increases linked to inflation, which locked in higher prices across the economy. Governments attempted to impose wage and price controls, but these measures failed and created market distortions.
In modern economies, the risk of a wage-price spiral is lower due to weaker union influence and increased labour market flexibility. However, sectors facing worker shortages – such as healthcare, logistics and hospitality – have seen rising wage pressures, which could contribute to inflationary risks.
Weak business investment and productivity declines
Stagflation is often accompanied by low business investment as companies struggle with rising costs, uncertain demand and high interest rates. When businesses hesitate to expand, hire or invest in new technology, productivity growth stagnates, making the economy more vulnerable to inflationary pressures.
In the UK, low productivity growth has been a long-term challenge, limiting economic expansion. When combined with inflationary pressures, this environment becomes a breeding ground for stagflation.
MONETARY AND FISCAL POLICY MISALIGNMENTS
Economic policy plays a crucial role in either preventing or exacerbating stagflation. Missteps in monetary and fiscal policy can make stagflation more severe or prolong its effects.
Loose monetary policy leading to inflation
When central banks keep interest rates too low for too long, excessive money supply growth can lead to inflation. If inflation rises while the economy is slowing, stagflation becomes a risk.
The Federal Reserve and the Bank of England faced this issue in the 1970s, as they kept interest rates low despite rising inflation. When inflation became entrenched, they were forced to aggressively raise rates, triggering deep recessions.
Excessive government spending and debt
Fiscal policy can also fuel stagflation if governments increase spending during inflationary periods. While stimulus measures are useful during recessions, excessive fiscal expansion when supply constraints exist can push inflation higher without improving growth.
The UK’s response to the Covid-19 pandemic, including massive stimulus spending and furlough schemes, helped sustain households but also contributed to inflation when supply chain issues persisted. The risk now is whether ongoing government borrowing and spending could add further inflationary pressures.
THE ROLE OF CENTRAL BANKS IN MITIGATING OR EXACERBATING STAGFLATION
Central banks have a difficult task when facing stagflation. Raising interest rates can curb inflation but worsen unemployment and economic stagnation. Keeping rates low may support growth, but at the cost of allowing inflation to spiral.
In the 1980s, the US Federal Reserve under Paul Volcker chose to prioritise inflation control by raising interest rates aggressively. While this move triggered a severe recession, it ultimately broke the inflationary cycle and restored economic stability.
In today’s environment, central banks must navigate similar challenges. How quickly and aggressively they raise interest rates will determine whether stagflation becomes a prolonged crisis or a temporary phase.
Investors and businesses closely watch central banks for signs of policy consistency. If central banks appear indecisive or overly reactive, inflation expectations can become self-fulfilling, reinforcing stagflation risks.
The challenge for today’s policymakers is to strike the right balance – tightening policy enough to control inflation without pushing the economy into deep stagnation.
STAGFLATION RISKS AND PREPAREDNESS
Stagflation is driven by a mix of supply shocks, demand-side weaknesses, policy missteps and central bank decisions. Understanding these factors can help investors identify risks early and adjust portfolios accordingly. While stagflation remains a complex challenge, historical lessons provide valuable insights into potential strategies for navigating its effects.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.