Stagflation: Why Do Markets Fear It?

Stagflation has been making financial headlines in recent months, particularly in reference to the US economy. Some analysts even refer to it as the 'dreaded S-word.' While this may sound like an exaggeration, stagflation is an economic condition that can be harmful to economies of any size. 

In this article, we will explore what stagflation is and why the word has gone viral. 

Please note that this material is for informational purposes only and not financial advice. 

What Is Stagflation?

Stagflation is an economic condition that involves high inflation rates, high unemployment rates with very low economic growth or even economic contraction. When stagflation kicks in, product and services prices rise, unemployment figures surge while the economy struggles to grow. For some economists, stagflation is close to what we could call a “perfect storm.”

The 1970s Stagflation Crisis: What Caused It And Resolution

The stagflation crisis of the 1970s was one of the most significant economic challenges of the 20th century, characterized by high inflation, rising unemployment, and slow economic growth. This period defied traditional economic theories, which typically suggested that inflation and unemployment had an inverse relationship.

What Happened?

During the early 1970s, the U.S. and other advanced economies experienced a severe economic downturn. Inflation soared, unemployment increased, and economic growth stagnated. The crisis was triggered by multiple factors, the most notable being the 1973 oil embargo imposed by the Organization of Petroleum Exporting Countries (OPEC). This event caused oil prices to quadruple, drastically increasing production costs across industries.

Why It Happened?

One of the main causes of stagflation was the oil price shock of 1973. OPEC, in response to Western support for Israel during the Yom Kippur War, cut oil exports to the U.S. and other allied nations. This sudden disruption led to an energy crisis, causing fuel prices to skyrocket. As oil was a fundamental input for production and transportation, the increased costs rippled through the economy, making goods and services significantly more expensive. This supply shock played a crucial role in driving up inflation while also slowing economic output.

Additionally, economic policies in the preceding years had contributed to worsening conditions. The U.S. Federal Reserve had pursued loose monetary policies throughout the late 1960s to reduce unemployment, increasing the money supply and fueling inflation. Further exacerbating the crisis, President Nixon ended the Bretton Woods system in 1971, removing the gold backing of the U.S. dollar. This led to a depreciation of the dollar, raising import prices and worsening inflationary pressures. The combination of these factors created a perfect storm that resulted in a prolonged period of stagflation.

Stagflation Consequences On The Economy

The most immediate effect of stagflation was soaring inflation, which reached double-digit levels in many countries. With prices rising rapidly, consumers saw a decline in their purchasing power, making essential goods and services less affordable. At the same time, businesses faced higher production costs, which led to increased prices for consumers and reduced profit margins. Many companies were forced to cut jobs, leading to rising unemployment, further weakening demand in the economy.

Another major consequence was the economic stagnation that followed. With high inflation and high unemployment occurring simultaneously, traditional policy tools proved ineffective. Governments that attempted to stimulate economic growth risked fueling inflation, while efforts to curb inflation often led to further job losses. Interest rates were eventually raised to extreme levels in an attempt to control inflation, making borrowing more expensive for businesses and consumers alike. As a result, the economic uncertainty of the 1970s discouraged investment and slowed overall productivity.

How The Stagflation Problem Was Solved

The crisis persisted into the early 1980s, until Federal Reserve Chairman Paul Volcker took drastic action. He raised interest rates aggressively (above 20% in 1981), causing a recession but ultimately breaking inflation. Simultaneously, pro-business policies under Ronald Reagan in the U.S. encouraged productivity and economic expansion, restoring confidence

By the mid-1980s, inflation was under control, economic growth resumed, and stagflation became a historical lesson in economic mismanagement.

Stagflation At The Gates? What Do Analysts Say

Market analysts do not hesitate to mention their fears about a potential stagflation period. Economists at Moody’s Analytics noted: “Inflation expectations are up. People are nervous and uncertain about growth. Directionally, we’re moving toward stagflation, but we’re not going to get anywhere close to the stagflation we had in the ’70s and the ’80s because the Fed won’t allow it.”

Economists at Bank of America (BoA) said that there is stagflation risk in the US economy but expect that the impact would not be as significant as in the 1970s. The BoA’s analysts noted that economic growth slows but it could remain at or above trend this year. They also mentioned that although inflation could pick up, mainly because of tariffs, it would likely stay below 3%.

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