What Is Stagflation? Causes, Examples, and Impact

Stagflation is one of the most challenging economic environments for investors. It's a toxic combination of rising prices and slowing growth that can weigh on consumer spending, pressure corporate earnings, and leave policymakers with limited options to address the problem. Understanding why stagflation occurs and how it can impact markets is critical for investors looking to protect their portfolios over the long term.

Stagflation is an economic environment defined by three traits: high inflation, weak economic growth, and elevated unemployment. While inflation typically surfaces when the economy is growing rapidly and the labor market is strong, stagflation breaks that pattern, forcing consumers and businesses to grapple with both higher prices and economic stagnation.

Economists generally view stagflation as one of the most difficult economic conditions to address because the tools central banks typically use to fight inflation (like raising interest rates) can further weaken the economy, while policies aimed at boosting growth can exacerbate inflation. Essentially, the traditional "medicine" for one problem only makes the other worse. Stagflation also tends to weigh on financial markets, making it a serious threat for investors.

There is no single cause of stagflation. Typically, a mix of factors come together to create it. Consider the following commonly cited causes.

Unexpected events like wars, natural disasters, or pandemics that disrupt supply chains are generally considered the main cause of stagflation. These disruptions can increase the cost of commodities like oil, natural gas, or steel. When this happens, businesses tend to raise prices to maintain their profitability, while also cutting back on hiring and production. As a result, the economy can experience high inflation, weak economic growth, and elevated unemployment at the same time.

Excessively loose monetary policy (via low interest rates) and aggressive government spending can increase the demand for goods and services beyond what the economy can supply, leading to an imbalance known as demand-pull inflation. When policymakers attempt to fix the problem by raising interest rates or cutting government spending, it can slow economic growth—bringing the stagnation part of the stagflation equation.

Structural issues like aging populations, weak productivity growth, labor shortages, or overly powerful unions can also weigh on economic growth or worsen inflation. While these problems are unlikely to create stagflation on their own, they can exacerbate it when an economy is grappling with economic policy missteps or supply shocks.

Sometimes inflation can lead to a negative feedback loop where workers demand higher pay to compensate for rising prices, which leads businesses to institute further price increases as they attempt to maintain their margins. Commonly known as the "wage-price spiral," this can create runaway inflation and reduce consumer spending, which stifles economic growth.

When inflation expectations are un-anchored, it means businesses and consumers believe central banks cannot control prices. As a result, people anticipate persistent price increases. This leads businesses to raise their prices to maintain their margins amid cost increases, while employees demand higher wages to preserve their purchasing power.

The most well-known stagflation example occurred in the United States in the 1970s. Year-over-year inflation soared from around 6% at the start of that decade to nearly 15% by 1980, while economic growth remained weak. The average unemployment rate was also high at roughly 6.2%.

There were three main causes for this period of stagnant economic growth and high inflation, according to the Federal Reserve Bank of Dallas. First, there were two oil price shocks (the 1973 oil crisis and the 1979 energy crisis), which lifted inflation substantially. Second, in 1971, President Nixon ended the Bretton Woods exchange rate system—which pegged the dollar to gold at a fixed price of $35 per ounce. This allowed for rapid money supply growth. And third, the Fed expanded the money supply and lowered interest rates early in the decade, exacerbating already rising inflation. Some economists also argue that heavy deficit spending in the late 1960s and early 1970s amid the Vietnam War and the expansion of Great Society social programs set the stage for these three factors to produce stagflation.

Stagflation was eventually brought under control after Federal Reserve Chairman Paul Volcker aggressively hiked interest rates beginning in the late 1970s. This triggered two recessions, but ultimately tamed inflation—with the help of falling oil prices.

The United Kingdom faced a similar stagflation crisis in the 1960s and 1970s caused by rising oil prices, excessive government spending, tax cuts, and a wage-price spiral enabled by powerful trade unions. The United Kingdom's year-over-year inflation peaked at 25% in 1975, while gross domestic product (GDP) fell for two consecutive years in 1974 and 1975, and the unemployment rate remained elevated.

Stagflation can weigh on a wide range of asset classes because it impacts corporate earnings and consumer spending. Historically, both stocks and bonds have struggled during periods of stagflation, while investments tied to real assets have been more stable. Real estate and real estate investment trusts (REITs), for example, can potentially perform relatively well because property values and rental income tend to rise alongside the cost of living. Meanwhile, Treasury Inflation-Protected Securities (TIPS) and precious metals like gold and silver often serve as safe havens for investors when consumer prices are rising and economic growth is weak.

Finally, defensive stock sectors tied to essential goods and services like consumer staples, healthcare, and utilities can potentially outperform growth stocks during periods of stagflation. However, every economic cycle is different, and past performance is no guarantee of future results.

Navigating a stagflationary environment typically leads investors to shift their asset allocation toward a more defensive and inflation-resistant mix. Investors might want to consider diversifying their investments, holding adequate cash reserves, and maintaining a long-term approach when stagflation becomes an issue.

Some experts also argue that more active portfolio management can be beneficial during periods of stagflation because broad market indexes tend to struggle and the performance gap between winning and losing companies can widen. This can potentially make finding businesses with pricing power and strong balance sheets valuable.

While rare, stagflation is a toxic economic combination that can weigh on consumers, businesses, and markets. Since it's also a difficult problem for policymakers to address, investors should consider monitoring key economic indicators like the Consumer Price Index (CPI), the unemployment rate, and GDP for early warnings signs that stagflation could be brewing.

Understanding the drivers and potential effects of stagflation can potentially help investors manage associated risks with more confidence. However, when economies experience stagflation, it tends to be a difficult time for investors—even when they proactively manage risk or implement hedging strategies.