RBA’s ‘worst nightmare’: What exactly is stagflation?

I’d wager that if you have come across the term ‘stagflation’, it was sometime in the past seven weeks or so. Before the onset of the Iran war, stagflation was a term that was last bandied about in mainstream economic reporting back in the 1970s. As such, if one isn’t a student of history, or studied economics at high school or university, the term might be completely unfamiliar.

Yet since the beginning of March, you can’t open the business section of a news article without coming across a mention of stagflation.

So today, let’s go over what this rather strange term means.

What is stagflation?

To understand the concept of stagflation we first need to recognise that this term is actually a portmanteau. Put simply, it is a word that has been created by merging two other words. Those two other words are ‘stagnation’ and ‘inflation‘.

When an economy experiences stagflation, it is suffering from high inflation and low, or stagnant, growth, at the same time.

This is actually a rather uncommon economic phenomenon. Under conventional economics, inflation occurs when the economy is running too hot for its own good. There is more money sloshing around than the economy can handle. As such, in lieu of increasing output beyond capability, an economy’s producers begin increasing prices. This cascades through the economy until prices are rising at a dangerous rate.

This inflation is known as ‘demand driven‘. It is easily countered, according to traditional economics anyway, by governments pumping the breaks. This can come in the form of higher taxes, or more commonly higher interest rates from central banks like the Reserve Bank of Australia (RBA).

These higher rates (or taxes) pull money out of the economy and break the cycle of rising prices. The trade-off is cooler economic growth, of course. Under traditional economic models, the trade-off between interest rates and inflation is akin to a see-saw. If one gets to high, all a central bank needs to do is jump on the other side. Balancing this see-saw is what most central banks, including the RBA, have spent the past 50 years doing.

What causes stagflation?

However, this model only works to manage demand-driven inflation. When it comes to supply-side inflation, the rulebook slides into impotence.

The last time the world saw a bout of stagflation was back in the 1970s. It was sparked by, you guessed it, an oil shock.

Back in the ’70s, the OPEC cartel decided to punish the United States and its allies for supporting Israel in the 1973 Yom Kippur War by restricting oil supplies. Oil skyrocketed, sparking rampant inflation throughout much of the world. This inflation was driven by a supply limit of oil, one of the fundamental inputs into most forms of economic activity.

Unlike the inflation we’ve become used to, it was not caused by excessive demand int eh economy. As such, central banks couldn’t just pull the interest rate lever and hike inflation away. Instead, they had to try and manage inflation as best they could, at the real cost of ongoing economic growth. As such, high inflation, held up by increased oil prices, persisted, while economic growth languished. Stagflation, in other words.

Stagflation is often cited as a central bank’s ‘worst nightmare’, because of the lack of easy solutions. Reducing rates will only stoke inflation, while increasing rates will prolong the downturn and increase unemployment.

This problem bedevilled the major economies of the world for years. It was only when OPEC split due to geopolitical tensions and the global oil price came back down in the early 1980s that this supply shock faded. By then, the world had responded to higher oil prices by, for example, diversifying their sources of oil, building more efficient cars and expanding the use of gas and nuclear power. Sure, inflation remained high over that decade. But growth picked up to match it.

Foolish takeaway

Stagflation is an unusual economic phenomenon only experienced a few times in recorded economic history. However, with inflation already uncomfortably in Australia before the Iran war, and a 21st century oil shock a distinct possibility (if it’s not already occurring), it may be a malady that we will once again have to navigate.

Tomorrow, we’ll look at how to position an investing portfolio to account for the possibility of stagflation, so stay tuned for that.

The post RBA’s ‘worst nightmare’: What exactly is stagflation? appeared first on The Motley Fool Australia.

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Motley Fool contributor Sebastian Bowen has no position in any of the stocks mentioned. The Motley Fool Australia’s parent company Motley Fool Holdings Inc. has no position in any of the stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.