Stagflation creates a difficult challenge for policymakers. Unlike standard recessions, where central banks can stimulate growth through lower interest rates or periods of high inflation, where they can tighten monetary policy, stagflation demands a delicate balance between controlling inflation and supporting economic growth.
Governments and central banks have historically struggled to respond effectively to stagflationary conditions, as policies designed to combat inflation often worsen economic stagnation, while those aimed at stimulating growth risk fuelling further inflation. Understanding the potential policy responses to stagflation – and their impact on financial markets – can help investors anticipate risks and opportunities when navigating economic uncertainty.
MONETARY POLICY: INTEREST RATES, MONEY SUPPLY CONTROL and INFLATION TARGETING
Interest rate adjustments: A difficult balancing act
One of the primary tools used by central banks to combat inflation is interest rate policy. Raising interest rates makes borrowing more expensive, slows down consumer spending and reduces inflationary pressures. However, in stagflationary environments, higher interest rates can also further weaken economic growth, exacerbating unemployment and business slowdowns.
During the 1970s stagflation crisis, central banks initially hesitated to raise interest rates aggressively, fearing a recession. This allowed inflation to become deeply embedded in the economy. By the late 1970s, policymakers had no choice but to act decisively. US Federal Reserve chairman Paul Volcker raised interest rates to nearly 20% in the early 1980s, deliberately triggering a recession to break the inflationary spiral. While painful in the short term, this strategy ultimately succeeded in restoring price stability.
For investors, a sharp increase in interest rates during stagflation has significant implications. Growth stocks, particularly in the technology sector, tend to suffer, as their valuations rely on future earnings, which become less attractive when interest rates rise. High-debt companies also struggle, as the cost of servicing loans increases. However, certain sectors – such as financials and commodities – may benefit from higher rates.
Money supply control: The role of quantitative tightening
Central banks also influence inflation through money supply management. Excess money creation can contribute to inflation by increasing demand beyond the economy’s productive capacity. In response, central banks may implement quantitative tightening (QT) – reducing the money supply by selling government bonds or allowing previous asset purchases to mature without reinvestment.
In the 1970s, excessive money supply growth contributed to stagflation, as governments sought to fund large deficits without controlling inflation. The Bank of England and the US Federal Reserve have since learned from this experience and now closely monitor broad money growth indicators.
When central banks tighten monetary policy through QT, bond yields rise and liquidity in financial markets declines. This typically weakens equity markets, particularly speculative investments that rely on abundant liquidity. Investors should monitor central bank balance sheets and look for signals of tightening policies, as these can impact market conditions.
Inflation targeting: Central banks’ role
Most modern central banks operate under an inflation-targeting regime. For example, the Bank of England’s mandate is to maintain inflation at 2%, using interest rates and monetary tools to achieve this goal. However, when inflation is driven by supply-side shocks, such as rising energy prices or supply chain disruptions, traditional inflation-targeting policies become less effective.
If a central bank raises rates too aggressively, it risks deepening economic stagnation. If it moves too slowly, inflation could become entrenched. Investors should pay close attention to statements from monetary policy committee meetings, as central bank communication provides important guidance on future policy moves.
FISCAL POLICY: GOVERNMENT SPENDING, TAXATION & SUPPLY-SIDE INTERVENTIONS
Government spending and stimulus measures
Governments can respond to stagflation with fiscal stimulus, such as infrastructure spending, subsidies or direct cash transfers to support households. While these measures can cushion economic downturns, they also risk fuelling inflation by increasing demand without addressing supply constraints.
During the Covid-19 pandemic, governments worldwide implemented massive fiscal stimulus through furlough schemes, business support loans and direct payments to individuals. While these policies prevented an immediate economic collapse, they also contributed to inflation when supply chains struggled to keep up with demand.
For investors, excessive government spending during stagflation can lead to higher government bond yields, as markets demand greater compensation for inflation risk. This can negatively affect fixed-income portfolios, particularly long-duration bonds. However, infrastructure-related stocks and industrial commodities may benefit from increased government investment.
Taxation policies: Raising or cutting taxes?
Tax policy is another tool governments can use to manage stagflation. In theory, reducing taxes can stimulate economic activity, but if inflation is already high, it risks increasing demand and worsening inflation. Conversely, raising taxes can reduce inflationary pressures but also slow growth further.
One common fiscal approach is windfall taxes on energy companies during periods of high inflation. In the UK, the government imposed temporary windfall taxes on oil & gas producers as part of efforts to address the cost-of-living crisis. While this may provide short-term relief to households, it can also discourage investment in the energy sector, reducing long-term supply and potentially exacerbating price volatility.
Investors should be mindful of tax policy changes, as sectors facing new tax burdens – such as energy, banking or large-cap corporations – may experience earnings pressure, while consumer-focused stimulus measures could boost certain industries, such as retail and utilities.
Supply-side interventions: Addressing structural weaknesses
Unlike demand-side policies, which focus on controlling spending, supply-side policies aim to boost economic efficiency and increase production capacity. These measures are often more effective in addressing stagflation in the long term.
Common supply-side policies include:
- Deregulation to encourage business investment and reduce operating costs.
- Investment in infrastructure and energy production to address supply shortages.
- Labour market reforms to improve productivity and reduce unemployment rigidities.
The UK government has historically used supply-side tax incentives to encourage business investment. For example, investment allowances and research & development (R&D) tax credits can stimulate productivity growth without worsening inflation.
For investors, sectors that benefit from supply-side reforms – such as infrastructure, manufacturing and technology – can present opportunities. However, these policies often take years to yield results, meaning their immediate impact on markets is limited.
POTENTIAL EFFECTIVENESS AND RISKS OF POLICY DECISIONS
Stagflation presents a policy dilemma: tightening monetary policy too aggressively can push the economy into recession, while fiscal stimulus risks prolonging inflation. Policymakers must strike a balance to avoid deepening either inflationary or stagnationary pressures.
Effectiveness of monetary tightening
While raising interest rates can eventually tame inflation, it comes at the cost of higher borrowing costs, weaker corporate earnings and slower economic growth. If inflation is primarily driven by supply-side factors, aggressive rate hikes may do more harm than good by worsening unemployment.
Risks of over-reliance on fiscal stimulus
Excessive government spending during stagflation can lead to rising public debt and inflationary pressures, particularly if financed through borrowing. Investors should be cautious about economies that continue running large deficits without addressing inflation risks, as this can lead to currency depreciation and reduced investor confidence.
Risk of policy mistakes
History has shown that delayed or inconsistent policy responses can worsen stagflation. The 1970s crisis was prolonged due to hesitant interest rate increases and poor fiscal discipline. Investors should be alert to signs of policy missteps, such as central banks failing to control inflation expectations or governments implementing contradictory policies.
INVESTOR CONSIDERATIONS WHEN ASSESSING POLICY CHANGES
- Monitor central bank statements and inflation reports to anticipate interest rate decisions.
- Assess fiscal policies for potential sector-specific opportunities or risks.
- Diversify portfolios to hedge against policy uncertainty, incorporating inflation-resistant assets such as commodities, infrastructure and dividend-paying stocks.
- Consider the long-term impact of supply-side reforms, particularly in infrastructure, energy and manufacturing.
By staying informed on policy developments, investors can position themselves strategically to navigate stagflationary environments while mitigating risks to their portfolios.
This Trustnet Learn article was written with assistance from artificial intelligence (AI). For more information, please visit our AI Statement.