Stagflation

Stagflation is among the most challenging macroeconomic conditions for policymakers to address because the standard policy tools for fighting inflation — monetary tightening and higher interest rates — directly worsen unemployment and growth, while the standard tools for stimulating a weak economy — fiscal expansion and monetary accommodation — directly worsen inflation. 

This policy dilemma makes stagflation qualitatively different from either inflation or recession alone, requiring an understanding of its causes, its manifestation in the historical record, its investment implications, and the policy responses that have proven effective against it. 

Stagflation is directly tested on the Series 65 examination in the context of macroeconomic analysis, the Phillips curve, monetary and fiscal policy, and investment portfolio management in difficult economic environments.

The Phillips Curve and Why Stagflation Was Considered Impossible

To understand why stagflation was so theoretically disruptive, it is necessary to understand the Phillips curve — the empirical relationship between inflation and unemployment that dominated macroeconomic policymaking from the late 1950s through the early 1970s.

New Zealand economist A.W. Phillips published his landmark 1958 paper The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957 in the journal Economica — demonstrating an empirical inverse relationship between unemployment and wage inflation in British data spanning nearly a century. 

The Phillips curve, as it became known, implied that policymakers faced a menu of choices — they could achieve lower unemployment at the cost of higher inflation, or lower inflation at the cost of higher unemployment, but could not simultaneously have both low inflation and low unemployment. 

This trade-off became the intellectual foundation of Keynesian demand management — policymakers would stimulate aggregate demand to reduce unemployment when unemployment was too high, accepting some inflation as the price, or would tighten policy to reduce inflation when inflation was too high, accepting some unemployment as the price.

Under the Phillips curve framework, stagflation was literally impossible by definition — if inflation was high, unemployment should be low, and if unemployment was high, inflation should be low. The two conditions could not coexist at elevated levels simultaneously because they reflected opposite positions on the same demand-determined trade-off curve.

Milton Friedman and Edmund Phelps independently challenged this framework in the late 1960s — before stagflation materialised — by introducing the concept of the natural rate of unemployment and the role of inflation expectations in the wage-setting process. 

Friedman's 1968 presidential address to the American Economic Association argued that the trade-off on the original Phillips curve was a short-run phenomenon that reflected workers being temporarily fooled by unexpected inflation into accepting lower real wages than they intended — and that in the long run, workers would adjust their expectations, the unemployment rate would return to its natural rate regardless of the inflation rate, and the long-run Phillips curve would be vertical. 

This natural rate hypothesis implied that supply shocks — which shifted both the inflation rate and the natural rate of unemployment simultaneously — could produce stagflation without contradicting the theoretical framework.

When OPEC's 1973 oil embargo produced exactly that — simultaneously higher inflation and higher unemployment — the stagflation experience validated the Friedman-Phelps critique of the naive Phillips curve and fundamentally altered the course of macroeconomic theory and policy.

The 1970s Stagflation — The Historical Record

The United States experience of stagflation in the 1970s remains the most significant and most studied episode of this condition in modern economic history. Understanding its sequence of events is essential for examination purposes and for understanding the policy lessons that have shaped central bank practice for the past four decades.

The origins of the 1970s stagflation predated the oil shocks. The Johnson administration's decision to finance simultaneously the Vietnam War buildup and the Great Society domestic spending programmes without raising taxes created substantial excess demand in the late 1960s — the economy was operating well above potential output, producing inflationary pressure that the Nixon administration and the Federal Reserve initially accommodated rather than restraining. 

The Federal Reserve's expansionary monetary policy during this period — allowing the money supply to grow faster than potential output — embedded inflationary expectations in wage-setting and price-setting behaviour throughout the economy, creating an inflationary inertia that made subsequent disinflation painful.

The first OPEC oil shock arrived in October 1973 when the Arab members of the Organisation of Petroleum Exporting Countries imposed an embargo on oil exports to the United States and other countries that had supported Israel in the Yom Kippur War. The price of oil quadrupled from approximately three dollars to twelve dollars per barrel within months — producing a massive adverse supply shock that simultaneously raised the cost of production for virtually every goods-producing industry in the economy. The supply shock raised prices — contributing to inflation — while simultaneously reducing the profitable level of output — contributing to recession and unemployment. The result was exactly what the naive Phillips curve said was impossible — inflation rose and unemployment rose simultaneously.

The Consumer Price Index inflation rate climbed from approximately three and a half percent in early 1973 to a peak of approximately twelve percent in late 1974. The unemployment rate rose from approximately four and a half percent in early 1973 to approximately nine percent by May 1975. Real GDP declined in five of the six quarters from late 1973 through early 1975 — a severe recession that proceeded simultaneously with double-digit inflation in ways that the demand-management policy framework of the prior two decades had not contemplated.

The policy response was ineffective. The Ford administration attempted to fight inflation through a voluntary programme called Whip Inflation Now — WIN — that achieved little beyond providing memorable marketing imagery. The Federal Reserve attempted to balance between fighting inflation and avoiding excessively tight policy that would deepen the recession — the result was policy that was neither sufficiently tight to break inflation nor sufficiently accommodative to support recovery, leaving the economy mired in stagflation through the mid-1970s.

A second oil shock arrived in 1979 following the Iranian Revolution — which removed Iran from global oil markets — and the subsequent outbreak of the Iran-Iraq War. Oil prices rose from approximately thirteen dollars per barrel in early 1979 to approximately thirty-five dollars by mid-1980 — a near-tripling that injected a second massive supply shock into an economy that had never fully recovered from the first. Inflation reached approximately fourteen and a half percent in 1980 — the highest level in postwar United States history. The combination of the second oil shock, persistent inflation expectations from the unresolved first episode, and the accumulated monetary accommodation of the 1970s produced the most severe stagflation of the entire period.

The Volcker Disinflation — The Resolution of 1970s Stagflation

The resolution of the United States stagflation episode came through the appointment of Paul Volcker as Chairman of the Federal Reserve Board by President Jimmy Carter in August 1979 and Volcker's implementation of an aggressive and uncompromising monetary tightening programme that explicitly prioritised breaking inflation over avoiding short-term economic pain.

Volcker announced a fundamental shift in the Federal Reserve's operating framework in October 1979 — abandoning the traditional practice of targeting the federal funds rate and instead targeting non-borrowed reserves, allowing the federal funds rate to rise to whatever level the market required to achieve the Reserve's reserve quantity objectives. This framework change signalled credibly to markets and the public that the Federal Reserve was prepared to allow interest rates to rise as high as necessary to break inflation — regardless of the cost to employment and growth in the short term.

The federal funds rate rose from approximately eleven percent in late 1979 to a peak of approximately twenty percent in June 1981 — a level that produced the sharpest monetary tightening in postwar United States history. The immediate consequences were severe — the economy contracted in 1980 and entered the deep recession of 1981 to 1982, during which the unemployment rate peaked at ten point eight percent in November and December 1982 — the highest level since the Great Depression. The prime rate at commercial banks reached twenty-one and a half percent.

The resolve paid off. Inflation fell from approximately fourteen and a half percent in 1980 to below four percent by 1983 — a disinflation of more than ten percentage points in three years. Once inflation expectations were broken — once workers and businesses accepted that the Federal Reserve would not accommodate inflationary wage and price increases — the underlying natural rate of unemployment reasserted itself and the economy began a sustained recovery in 1983 that lasted through most of the decade. The Volcker disinflation demonstrated conclusively that supply-shock-induced stagflation could be defeated through sufficiently credible and sustained monetary tightening — but at a cost of several years of elevated unemployment and output below potential.

The Causes of Stagflation — A Framework

Economic analysis identifies three primary causes of stagflation, each operating through a distinct mechanism.

Supply shocks are the most common cause — sudden adverse developments that simultaneously raise prices and reduce economic output. An oil price spike increases production costs across the economy — energy is an input to virtually every production process — raising the price of goods and services simultaneously with reducing the profitable level of production. 

The aggregate supply curve shifts leftward — for any given price level, less output is produced — producing higher inflation and lower output at the same time. Supply shocks can originate from commodity price spikes, natural disasters, geopolitical disruptions, trade restrictions, or any other development that adversely affects productive capacity or input costs.

Poor monetary policy can create stagflation when excessive monetary expansion creates inflationary expectations that become embedded in wage and price-setting — once workers expect inflation to be high, they demand higher wages to preserve real wages, which raises production costs, which raises prices further, which validates the original inflationary expectations in a self-reinforcing spiral. When this inflation spiral is running, the economy can simultaneously experience above-target inflation — produced by the embedded inflationary expectations and monetary accommodation — and below-potential output — produced by the supply-side cost pressures from high wage demands. This was part of the 1970s story — the Federal Reserve's failure to tighten sufficiently in the late 1960s created embedded inflationary expectations that persisted through the 1970s.

Structural economic factors — excessive regulation that raises production costs without improving productive capacity, labour market rigidities that prevent wages from adjusting to changes in productivity, or long-term supply constraints in critical industries — can contribute to stagflationary conditions by raising the natural rate of unemployment simultaneously with inflationary pressures from other sources.

The Policy Dilemma — Why Stagflation Is So Difficult to Address

The defining characteristic of stagflation from a policy perspective is the contradiction it creates for the standard macroeconomic policy toolkit — every available tool that addresses one of stagflation's components simultaneously worsens another.

Monetary tightening — raising interest rates to reduce inflation — directly worsens growth and unemployment by increasing the cost of borrowing, reducing investment, slowing consumption, and depressing asset prices. This is the standard anti-inflation medicine. But in a stagflationary environment where unemployment is already elevated and growth already stagnant, the medicine that cures inflation aggravates the recession component.

Monetary easing — reducing interest rates to stimulate growth and employment — directly worsens inflation by increasing the money supply, lowering borrowing costs, stimulating demand, and potentially embedding even higher inflationary expectations. This is the standard anti-recession medicine. But in a stagflationary environment where inflation is already elevated, the medicine that stimulates growth pours fuel on the inflationary fire.

Fiscal expansion — increasing government spending or reducing taxes to stimulate demand and employment — faces the same dilemma as monetary easing. Fiscal contraction — reducing spending or increasing taxes to dampen inflation — faces the same dilemma as monetary tightening.

The Volcker resolution established the policy precedent that has guided central bank practice since — when a central bank faces stagflation, it should prioritise the inflation component even at the cost of worsening the unemployment and growth components, because the long-run cost of embedded inflationary expectations — which grow progressively harder to break the longer they persist — substantially exceeds the cost of the short-run recession required to break them. Federal Reserve independence and inflation targeting frameworks — adopted by most major central banks since the 1980s — were designed specifically to prevent the recurrence of the monetary policy mistakes that allowed inflationary expectations to become embedded in the first place, eliminating the political pressure that led to accommodative policy at the wrong moments.

Investment Implications — Portfolio Management in Stagflation

For investment professionals operating under the fiduciary duty of the Investment Advisers Act of 1940 and the care obligation of Regulation Best Interest at 17 CFR 240.15l-1, understanding the asset class implications of a stagflationary environment is essential for constructing portfolios that protect client wealth during one of the most challenging macroeconomic conditions.

Equities generally perform poorly during stagflation — the combination of rising inflation, rising interest rates used to combat that inflation, and slowing economic growth creates a triple headwind. Rising rates increase the discount rate applied to future earnings, reducing present values. Slowing growth reduces the earnings themselves. Rising input costs — from the supply shocks that typically cause stagflation — compress margins. Historically, equity markets performed very poorly in real terms during the 1970s stagflation — the S&P 500 produced a cumulative real return of approximately negative forty percent from 1972 through 1982, a decade of genuine wealth destruction for investors in conventional equity indices.

Long-duration fixed income performs particularly poorly during stagflation — rising inflation erodes the real value of fixed coupon payments, and rising interest rates reduce bond prices through the duration mechanism. Long-term government bonds — which carry the highest duration and the greatest sensitivity to interest rate changes — typically suffer the largest losses in stagflationary environments. The 1970s were devastating for bond investors in real terms as inflation systematically destroyed the purchasing power of fixed coupon receipts.

Real assets — commodities, real estate, inflation-linked securities, and natural resource equities — have historically provided the strongest protection during stagflationary periods. Commodities benefit directly from the supply shocks that typically cause stagflation — if the shock is an oil price spike, oil and energy commodity positions profit directly. Broader commodity indices tend to preserve real value during inflationary periods because commodity prices rise with general price levels. Treasury Inflation-Protected Securities — TIPS — provide a direct hedge against inflation by adjusting principal with the Consumer Price Index — their real yield is guaranteed regardless of what inflation proves to be, making them the purest form of inflation protection in the fixed income universe. Real estate provides partial inflation protection through rent escalation clauses that link rental income to inflation measures, though rising interest rates during the anti-inflationary policy response create valuation headwinds.

Short-duration fixed income and cash instruments — Treasury bills, money market funds — preserve capital in nominal terms and benefit from the rising nominal interest rates that accompany anti-inflationary monetary tightening, providing better relative performance than long-duration bonds during the rate-rising phase of the response even though they do not provide inflation protection in real terms.

The 2021 to 2023 Episode — Near-Stagflation Risks in the Modern Era

The COVID-19 pandemic and its aftermath raised concerns among economists and market commentators about potential stagflation for the first time since the 1970s — creating a useful contemporary context for understanding the concept.

The combination of massive fiscal stimulus — the CARES Act of 2020 under Public Law 116-136, the American Rescue Plan Act of 2021, and related legislation — with supply chain disruptions from the pandemic and the subsequent war in Ukraine produced a surge in consumer price inflation beginning in 2021 that reached nine point one percent for the twelve months ending June 2022 — the highest CPI reading in forty years. Simultaneously, labour markets were unusually tight by 2021 and 2022 standards, with unemployment falling rapidly and wage growth elevated — different from the classic stagflation combination of high inflation and high unemployment.

The Federal Reserve's response — raising the federal funds rate by five hundred and twenty-five basis points from March 2022 through July 2023, the most aggressive tightening cycle since the Volcker era — successfully reduced inflation without producing the severe recession that accompanied the 1970s disinflation. The so-called soft landing achieved by the FOMC under Chair Jerome Powell — bringing inflation substantially down toward the two percent target while maintaining near-full employment — was widely cited as evidence that the Federal Reserve's inflation-fighting credibility and better communication of policy intentions made the 2021 to 2023 disinflation substantially less costly than the Volcker disinflation of 1980 to 1983.

Examination Relevance and Key Takeaways

Stagflation is tested on the Series 65 examination in the context of macroeconomic analysis, the Phillips curve, the limitations of demand-management policy, monetary policy responses, and investment portfolio management implications.

The key points to retain are these.

Stagflation is the simultaneous occurrence of high inflation, stagnant or declining economic growth, and elevated unemployment — first named by British politician Iain Macleod in 1965 and most severely experienced in the United States during the 1970s. The term combines stagnation and inflation. Stagflation was considered theoretically impossible under the original Phillips curve framework — first published by A.W. Phillips in 1958 — which implied an inverse relationship between inflation and unemployment that precluded both being simultaneously elevated. Milton Friedman and Edmund Phelps independently challenged the Phillips curve in the late 1960s by introducing the natural rate of unemployment and the role of inflation expectations — their framework explained stagflation as the result of supply shocks that shift the short-run Phillips curve rightward, producing a worse trade-off between inflation and unemployment at every level of demand.

The primary cause of stagflation is adverse supply shocks — particularly the OPEC oil embargoes of 1973 and 1979 that raised production costs economy-wide while simultaneously reducing the profitable level of output, pushing the aggregate supply curve leftward. Secondary causes include poor monetary policy that allows inflationary expectations to become embedded and structural rigidities that raise the natural unemployment rate. The 1973 to 1982 United States stagflation produced peak CPI inflation of approximately fourteen and a half percent in 1980 and peak unemployment of approximately ten point eight percent in November to December 1982. The Volcker disinflation — achieved by raising the federal funds rate to a peak of approximately twenty percent in June 1981 — broke the inflationary expectations at the cost of the deepest recession since the Great Depression, establishing the policy precedent of prioritising inflation control even at the cost of short-term unemployment.

The stagflation policy dilemma is that every standard tool addresses one component while worsening another — monetary tightening reduces inflation but worsens growth and unemployment, while monetary easing stimulates growth but worsens inflation. This makes stagflation the most challenging macroeconomic condition for policymakers. Investment implications — equities perform poorly as rising rates, slowing growth, and margin compression create triple headwinds; long-duration fixed income performs very poorly as rising inflation and rising rates erode real values and reduce prices; real assets including commodities, real estate, and TIPS provide the strongest inflation protection in stagflationary environments; short-duration instruments and Treasury bills provide better relative performance than long bonds during the rate-rising phase of the anti-inflationary policy response.