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Stagflation - what’s the big story?

High on the list of market worries at mid year was the risk of stagflation. As inflation hits multi decade highs and economists slash forecasts for GDP growth around the world, it’s not difficult to see why alarm bells are ringing. A case in point is the UK economy, where growth has slowed to an 18-month low and inflation is forecast to top 13% over the winter. So what is this stagflation phenomenon? And why is it seen as such a potent negative force by financial markets?

The answer is that, in one word, stagflation encapsulates three negatives: stagnation of economic growth, inflation of prices and rising unemployment. It’s technically known as ‘recession-inflation’. The term first gained currency in the 1970s during a similar period of bleak economic performance. Financial markets struggle in this situation, as the means of escape from it are not obvious. But controlling prices is often the first objective.

Inflation hits growth, by reducing the purchasing power of consumers. But with consumers on the back foot, growth stalling and unemployment rising, it is hard to explain why prices continue to spike. For this reason, many economists consider stagflation to be a logical impossibility. So what triggered the bouts of stagflation seen in recent decades? Typically, it’s an external shock to commodity prices, such as the OPEC oil embargo of the 1970s. Or indeed the Russian invasion of Ukraine. 

The focus of central banks is restraining inflation, ensuring ‘price stability’. There has been tough talk on interest rates recently from the US Federal Reserve (Fed) and the European Central Bank. With July PCE inflation at 6.3%, against a target of 2%, the Fed is promising ‘restrictive rates’ for some time. But can the Fed ignore the impact of rate hikes on growth? During periods of stagflation, central banks are in a bind. Tighter policy tackles only one part of a triple-edged problem. And risks making the other two elements worse.

Financial markets are waiting nervously to see whether inflation control or economic growth will eventually win out. Sentiment can swing from week to week, leading to bouts of volatility. Sometimes ‘bad news is good news’, when the heightened risk of recession convinces markets that aggressive interest rate policies will be abandoned. This could potentially allow valuations to take off again, although stock markets would normally prefer strong economic growth. In the meantime, uncertainty prevails.