What is stagflation and how does it affect you?

In 1965, Conservative politician Iain Macleod coined a term which would still be used decades later. In a speech in front of the House of Commons he said:

“We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation and history in modern terms is indeed being made.”

Since then, whenever the term stagflation is used it creates a sense of fear among economists. Below we have explained what this is and how it affects you.

As a definition, stagflation describes the state of an economy which is simultaneously experiencing high inflation and low economic growth. While this sentence may be overwhelming to understand at once, it can be easier to explain with a little economic context. 

A healthy, growing economy is good news for everyone, as it reduces unemployment and provides the Government with more tax revenue to spend on public services, such as the NHS and transport. This is why in periods of low economic growth, the Bank of England (BoE) will usually lower interest rates to encourage spending. In essence, a lower base rate means borrowing becomes cheaper and saving becomes less attractive. Companies are encouraged to take out a loan to expand their business while the individual consumer will be more inclined to take out a mortgage or finance a new car. All this spending increases economic growth.  

This form of monetary policy works because lower interest rates will increase inflation too, which further encourages people to spend money to avoid paying more in the future.  

Now, in some circumstances, the economy can act irrationally by coupling slow economic growth with high inflation in a single period. In such circumstances it becomes tough for the BoE to bring things back to normality.

On the one hand, if the BoE lowers interest rates it will probably not have its desired impact of promoting sufficient economic growth. Inflation is already high, which means consumers are unlikely to be enticed into spending more to grow the economy. If it does promote some form of economic growth, then this will be at the expense of exacerbating inflation further, making it more difficult for consumers to afford everyday items.

Alternatively, if they raise interest rates to combat rising inflation, then borrowing will become too expensive and keep economic growth low. In such circumstances it may also force people to stop spending altogether.  

Essentially, however the BoE moves interest rates it will worsen either the cost of living or economic growth.

Stagflation has generally followed severe economic shocks in history. For example, this occurred during the oil shock in the 1970s and, to a smaller extent, was felt after the financial crash of 2008.

In the 1970s, stagflation first occurred after the price of oil doubled between 1973 and 1975. When this happened, it had a domino effect on the world economy, pushing prices up in a variety of sectors. Prices rose because oil is a key commodity in the transportation of goods and services, so when it became more expensive so did the supply chain for a range of goods and services. Added to this, a series of macroeconomic factors also caused a low growth environment which, coupled with this surging inflation, created stagflation.  

^{Photo taken in the United States of America during the energy crisis in the 1970s. Many petrol stations were on rationed supply during this time. Photo credit: Shutterstock.} 

Ultimately, as in the definition, stagflation is caused by a period of high inflation and low economic growth. What causes a sluggish economy and high inflation to occur simultaneously will depend on the unique circumstances of each individual event.

At its core, stagflation will affect the consumer on an affordability level. If the cost of living increases, then it is best to sit down and evaluate your own personal finances. Reading the news on the rising inflation can feel overwhelming, which is why figuring out how to manage your own finances can give you peace of mind.

Alternatively, you can speak to your own financial adviser to figure out the best plan for your mortgage payments, cutting back your expenditure, and your investments to reach your own financial goals.

Our preferred independent financial advisers, Kellands Hale, do just that, and you can book an appointment with them today.

As stated in the inflation guide, new house prices can see the most upward movement during periods of high inflation. During periods of stagflation, a similar effect can be felt.

In an environment where raw materials are getting more expensive, the cost of housing construction can increase too which means developers can up their prices on the final product to keep in line with inflation.

Stagflation will generally have a negative impact on stock market prices.

During periods of high inflation consumers tend to cut back on spending. This means a variety of sectors take on less business and therefore make less profit. For example, if you are faced with an increase in grocery costs it is likely that you will put off a planned staycation by the seaside. As a result, hotels, restaurants, and other businesses will lose out on your spending which, if experienced on a large scale, will eat away at their profits. Less profit generally means a smaller dividend pay-out for investors, which will force them to look at other forms of investing.

As seen in the 1970s, the price of gold has conserved the wealth of its investors in times of stagflation.

This, in part, is due to the yellow metal’s reputation as a safe haven during economic uncertainty. Our guide on gold explains the behaviour of gold in greater detail, but because there is only a finite supply of this resource in the world a strong demand for it will drive its price upwards.

The Government and the BoE can employ several monetary and fiscal policies to soften its effects.

How they attempt to do this will depend on the unique nature of the economy at the time. Some may believe controlling inflation is more urgent than economic growth, and vice versa. The bigger problem of the two is likely be the first one to solve.

Otherwise, there is consensus among some economists that stagflation will correct itself over time. In the 1970s, stagflation rose from a surge in oil prices and, once these prices began returning to normality, stagflation subsided.