Understanding Stagflation and the Risk of Its Recurrence

Source: Congressional Research Service (via Open CRS)

The slowing of economic growth and the rising rate of inflation in early 2008 have given rise to concerns that the U.S. economy is at risk of an episode of stagflation. Stagflation describes an economy that is characterized by high rates of both unemployment and inflation. The term came into popular use in the 1970s to describe the economy at that time. The unemployment rate reached 9.0% in May 1975 and a high of 10.8% in November 1982. The rate of consumer price inflation reached 12.2% for the 12-month period ending in November 1974, and 14.6% for the 12-month period ending in May 1980. Inflation is currently about 4% and the unemployment rate is near 5%, both well below the rates in the 1970s that were cause for alarm. Nonetheless, higher oil prices and turmoil in financial markets have led some to warn that stagflation may be in our future.

The key to understanding the nature of stagflation is the natural rate of unemployment. That is the lowest rate of unemployment consistent with a stable rate of inflation. Below that rate, inflation tends to accelerate. In the view of the natural rate model, unemployment and inflation rates may be relatively high at the same time, and they may even rise simultaneously for a time, particularly if inflation and the natural rate of unemployment are rising at the same time. What is unlikely to happen, however, is for the unemployment rate to be high and for the inflation rate to continue accelerating. If the unemployment rate is above the natural rate, then cooling labor and product markets would be likely to reduce upward pressure on wages and prices. Stagflation in the 1970s coincided with two large “oil shocks.”

A large increase in the price of oil can have macroeconomic consequences in terms of higher inflation, higher unemployment, and lower output. Both the inflation and output effects of energy shocks are temporary, however. Once prices adjust, the economy returns to full employment and its sustainable growth path. It is not the level of energy prices that affects economic growth and inflation, but rather the change in energy prices. Thus, if policymakers are concerned with the effect of energy prices on output and inflation, they should focus more on rising energy prices than “high” energy prices, even if the high prices are permanent. Although stagflation is understood to be high rates of both inflation and unemployment, it is not clear how high those rates have to be to merit the designation. Whether or not rates less than those observed in the 1970s constitute stagflation may be a subjective matter.

Recent unemployment and inflation rates are not nearly as high as they were in the 1970s. Some economists, however, fear that the recent expansion in monetary and fiscal policy, at a time when unemployment is low but rising and energy prices are rising, could lead to a new bout of stagflation in the near future. Although policy may not be able to prevent episodes of stagflation from occurring, there may be enough understanding of the underlying causes to avoid making conditions substantially worse.

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