Rohman Rory HemleyIf you’re following the news, you may feel bombarded by stories about Covid-19, the United States involvement in Afghanistan, and fears of the possibility of stagflation. You may be wondering, what is stagflation? If the word sounds familiar, it is because it is a combination of stagnation and inflation. If you have an understanding of stagnation and inflation, you are well on your way to understanding stagflation. For those that do not have a background in finance or googled the word and feel overwhelmed by the information they come across, do not worry. We will break down stagflation, and by the end of this post, readers will have a better understanding of the term.
WHAT IS STAGFLATION?
Stagflation is an economic term that occurs when inflation is high and economic growth slows down, along with high unemployment. As you can tell, a third factor is introduced in the definition that was not mentioned in the introduction, and that is high unemployment. Further breakdown of these three components will give a better understanding of the term. First, let’s look at inflation.
Inflation
Inflation is described as the increase in the price of goods and services. Another way of looking at inflation is as a decrease in purchasing power. If a soda costs $1 today and a year from now that same soda costs a dollar, then there is no inflation. If the soda price increased to $1.50 or $2, then inflation increased 50% or 100%. It is important to know that inflation is not calculated by a single product, such as a soda. The U.S. Bureau of Labor Statistics (BLS), which is responsible for tracking and calculating inflation, does so by monitoring the prices of a range of goods and services commonly used by consumers.
The Federal Reserve (the United States Central Bank) recommends an inflation rate of 2% “for maximum employment and price stability.” The Federal Reserve operates under the assumption that at 2%, individuals and businesses can make better decisions, ensuring a smoother economy. Two percent is not set in stone and may change in the future if economic circumstances change. According to the U.S. Bureau of Labor Statistics, the current inflation rate at the end of July 2021 is 5.4%, up 4% from last year’s 1.4%. For stagflation to occur, high inflation along with slow economic growth and high unemployment must also be in play.
Slow Economic Growth
The second component of stagflation is slow economic growth. Economic growth is measured by Gross Domestic Product (GDP). The Bureau of Economic Analysis (BEA) describes GDP as the “value of the final goods and services produced in the United States.” GDP is a measure of the percentage change of economic productivity on a year-to-year basis. According to the BEA, which tracks GDP, the 2021 third quarter GDP is 6.3%. Economists agree that a healthy GDP for the United States is around 2% to 3%. The current GDP of 6.3% is a result of the economic recovery due to the economy opening back up after the Covid-19 lockdown. It’s unlikely for the United States economy to maintain a 6% GDP in the long run, and a slowdown pass to 2% could contribute to stagflation. Another word for slow economic growth is “economic stagnation,” which is what we see in the makeup of the word “stagnation.”
High Unemployment
The BLS is responsible for measuring the unemployment rate in the United States. They do this by a survey of a sample of a certain number of households in the United States. They determine the size of the labor force and what percentage of the labor force is employed. The labor force is made up of people currently employed and those that are not employed but are looking for work. If a person is able to work but is not looking for work, they are considered a discouraged worker and are not counted in the labor force.
Bloomberg.com states that “To economists, full employment means that unemployment has fallen to the lowest possible level that won’t cause inflation.” That number is around 4-5%. The assumption here is that if unemployment is below the 4-5% mark, employers will be competing for fewer workers. Employers compete by offering higher pay when there are fewer workers. This will then lead to higher inflation. The current unemployment rate as of August 2021 is 5.2%.
Final Thought
When it comes to stagflation, many things have to go wrong. An economy must be facing high unemployment, high inflation, and a slowdown in economic production. We are accustomed to hearing about these situations independently or as a couple but not usually in a trio.
We are more familiar with recessions, which are a fall in GDP in two consecutive quarters. If a recession is prolonged, high unemployment usually follows. The decline in demand causes businesses to lay off workers, and if demand continues to fall, so will prices. The falling of prices, also known as deflation, can follow during a prolonged recession due to the fall in demand.
Stagflation is not a common phenomenon due to the fact that when unemployment rises, prices usually fall, but this occurrence happened in the 1970s. Even though the United States experienced stagflation in the 1970s, there are a few different theories for the cause provided by economists. Some believe it was caused by conflicting fiscal policies, while others believe it was the sharp rise in oil prices. These are only some of the explanations of stagflation in the 1970s. Nonetheless, unemployment, GDP, and inflation are carefully watched to prevent such an occurrence.