What is the meaning of stagflation? The definition, causes and economic theories of this phenomenon, with a focus on how to invest if there is stagflation.
What is the meaning of stagflation? This term refers to a particular economic situation in which two phenomena merge: stagnation and inflation.
stagflation occurs, therefore, when an economy simultaneously presents stagnant economic growth, high unemployment and high inflation.
The concomitance of these factors is rare, but always possible and with concrete examples - even if very few - in history.
The mechanism that sets stagflation in motion includes a fairly evident reduction in demand and higher unemployment. With consumers who spend little and who see their incomes stagnant or decreasing, slow growth is triggered. In a normal market economy, this situation would favor a lowering of prices.
However, if external factors - such as shocks to the supply of raw materials - push inflation up, while other conditions weaken the recovery, the stagflation picture materializes.
What is stagflation? Meaning and definition
To understand the definition of stagflation, we must first clarify the meaning of the two terms that make up this word: stagnation and inflation. In fact, their fusion generates the phenomenon in question.
stagnation refers to a situation in which economic growth is slow, companies do not produce at full capacity and unemployment increases. In practice, production and national income neither increase nor decrease. If it continues for a long time, this phase translates into a contraction in economic growth.
Inflation occurs when the prices of goods and services continue to increase, making the overall cost of living higher.
In short:
Stagflation is a condition in which economic growth is flat or very slow, unemployment rises, and at the same time inflation becomes higher.
Usually, when unemployment is high, spending decreases, as do the prices of goods. Stagflation occurs when the prices of goods rise despite weakened growth and demand.
Because of the convergence of these opposing factors, stagflation can be a particularly difficult problem for central banks. Most policies aimed at reducing inflation - such as raising interest rates - tend to slow demand and growth, while spending incentives - such as lower interest rates - push up prices.
The use of Quantitative Easing or Quantitative Tightening can also generate contrasting effects on liquidity in the market. And, therefore, on money available to spend and invest.
Addressing and overcoming stagflation, therefore, can be a real dilemma for politicians and central bankers.
Stagflation according to economic theories
What causes stagflation? There are at least two economic theories that attempt to provide an answer.
The first states that this economic phenomenon is based on a sudden shock on the supply side of a crucial raw material such as, for example, oil.
A increase in the cost of oil, which follows a drastic reduction in its supply due to disruptions in supply chains or for other reasons, reduces the productive capacity of an economy.
As transportation prices rise, the production of goods and their delivery to store shelves becomes more expensive and there is a leap forward in all prices.
In essence, the supply and demand of the raw material are no longer balanced because there is less oil - to cite the example given - compared to the requests which, consequently, becomes more expensive.
Another theory to explain stagflation calls into question wrong monetary policies. Allowing inflation to rise freely and then suddenly intervening to stop it - by hitting higher rates - is an example of bad monetary policy. A higher cost of money affects and weakens growth, while the effects on prices are probably slower to materialize.
What are the main causes of stagflation?
Among the causes that more than others can trigger stagflation stand out:
- Increase in the price of oil: stagflation is often caused by a shock on the supply side. For example, rising commodity prices, such as oil prices, cause business costs to rise (transport is more expensive). This leads to a higher inflation rate and lower GDP;
- Falling Productivity: If an economy experiences a decline in productivity, workers become more inefficient; costs increase and production decreases;
- Structural Rise in Unemployment: If there is a decline in traditional industries, we may have more structural unemployment and lower production. This results in higher unemployment, even as inflation increases;
- Supply Shock: If supply chains are disrupted, prices rise.
Stagflation in World Economic History: Two Examples
When trying to explain stagflation in a practical way, the historical reference is that of the 1970s.
The most famous example of this particular economic situation dates back to the oil crisis of the 1970s. At that time, OPEC placed an embargo on oil exports to Western countries that had supported Israel in the Yom Kippur War against Syria and Egypt in 1973.
As a result, global prices for crude oil - and therefore gasoline and petrochemicals - skyrocketed. Increased operating costs for companies reduced profitability and productivity, dramatically increasing the cost of goods and services.
Consumer spending fell significantly and many companies had to downsize due to the decline in demand.
The economy fell into recession in 1974, and although the embargo was lifted in March 1974, oil prices continued to rise.
The stagflation scenario returned to the fore in 2022. In that year, the global economic recovery from the Covid pandemic was abruptly halted by the outbreak of war in Ukraine. The conflict accelerated the rise in prices, which were already on the rise, especially in the energy sector, and compromised all indications of economic growth.
Europe appeared particularly vulnerable, given its heavy dependence on Russian gas, and GDP projections were all oriented towards a decline. Even in the US, where prices increased, a recession scenario was hypothesized, which was then averted.
In the wake of the events of 2022, Germany entered a technical recession, with an industrial crisis triggered by high energy prices and other external factors such as the reduction in trade with China. The crisis is still ongoing in 2025. However, inflation has started to fall and therefore the specific situation of stagflation has not occurred.
How to Invest During Stagflation?
Since stagflation presents itself as a complex economic situation, the best way to avoid unpleasant surprises with your financing is to follow the advice that is always valid: diversify.
In detail, to avoid the risk of losses as much as possible, it is good to keep in mind some general indications:
- raw materials can have good performances because they tend to maintain their high value during periods of high inflation. Gold, silver, oil and agricultural products are assets to focus on;
- real estate is an asset class that can protect against inflation and economic slowdown. They can increase in value over time and generate rental income for owners;
- bonds issued by the government which protect against inflation, adjusting their capital value based on changes in the consumer price index (CPI), are a good investment. With stagflation, they provide a return that is above inflation;
- defensive sector stocks such as consumer staples, healthcare, and utilities are good stagflation investments. These sectors provide essential goods and services that people need regardless of economic conditions. Even during periods of high inflation and stagnant growth, people will still need electricity, healthcare, and basic consumer products.
In general, it is important to remember that stagflation can impact investments in different ways and across different asset classes, causing increased volatility and uncertainty in financial markets.
Therefore, when building your investment portfolio, you should also consider the stagflation hypothesis to adjust your asset allocation and diversification strategies based on your risk tolerance and return goals.
How to Fight Stagflation
To avoid stagflation, governments adopt economic, monetary and fiscal policies, but there is no foolproof way to get the economy back on track, as it is very difficult to solve inflation and stagnant or slow growth at the same time.
One solution to make the economy less vulnerable to stagflation is to reduce the economy’s dependence on oil or crucial raw materials such as energy. Since rising commodity prices are the main cause of stagflation, having a supply mix especially in the energy sector is crucial for countries.
One solution is productivity-boosting policies, which allow for higher growth without inflation.
Carefully assessing the macroeconomic environment and finding a balance between multiple factors, such as money supply, interest rates, demand, employment rate and geopolitical tensions are crucial moves against stagflation.
Original article published on Money.it Italy. Original title: Cos’è la stagflazione? Definizione, significato e cause economiche
