Stagflation is one of the words economists least like to use, because it describes one of the hardest situations for policymakers to fix. It means an economy suffering from weak growth and high inflation at the same time. With oil prices sensitive to tensions around the Strait of Hormuz and bond yields elevated, the term has been creeping back into market commentary, so it is worth understanding what it means.
Two problems at once
Normally, inflation and growth tend to move together. When an economy is booming, demand is strong, businesses raise prices and inflation picks up. When the economy slows, demand weakens and inflation tends to cool.
Stagflation breaks that pattern. Growth is weak or the economy is shrinking, unemployment may be rising, and yet prices keep climbing. The name combines stagnation and inflation.
What causes it
The classic cause is a supply shock, where something pushes up costs across the economy rather than demand pulling prices higher. A sharp rise in energy prices is the textbook example. When oil and gas become more expensive, businesses face higher costs for transport, heating and production. They pass some of that on to customers, so inflation rises. At the same time, households have less money left over for other spending, so growth slows.
The 1970s are the best-known episode. Oil embargoes and supply disruptions sent energy prices soaring, and many Western economies, including the UK, experienced high inflation alongside weak growth and rising unemployment. Our explainer on how oil shocks transmit into inflation covers that chain in more detail.
Other causes can include persistent wage-price spirals, where workers seek higher pay to keep up with prices and businesses raise prices to cover higher wages, or policy mistakes that let inflation expectations become entrenched.
Why central banks struggle
Stagflation is so difficult because the usual tools pull in opposite directions. To fight inflation, a central bank raises interest rates, which slows the economy further. To support growth, it cuts rates, which risks letting inflation run hotter.
Central banks generally decide that keeping inflation under control is the priority, because high inflation that becomes embedded can do lasting damage. But that can mean accepting a period of weak growth or even recession. Understanding the language they use helps here, and our guide to hawkish versus dovish explains how to read their signals.
How markets tend to behave
Stagflation is a tough backdrop for many traditional investments. Shares can suffer because profits are squeezed by higher costs and weaker demand, while higher interest rates reduce what investors are willing to pay for future earnings.
Government bonds can also struggle, because inflation erodes the value of fixed payments and central banks may keep rates high. That is unusual, since bonds normally offer some protection when growth weakens.
Commodities, particularly energy, often perform better, since rising raw material prices are frequently part of the cause. Gold has historically attracted interest as a store of value when inflation is high and confidence in other assets is low, although its performance depends heavily on real interest rates.
In currency markets, the picture depends on which country is more exposed. An economy that imports most of its energy can see its currency weaken in a stagflationary shock.
Not every slowdown with inflation is stagflation
It is worth being careful with the word. A few months of sticky inflation while growth cools is not the same as the prolonged, painful combination seen in the 1970s. Commentators sometimes use the term loosely to describe a risk rather than a reality. The useful approach is to watch the data, particularly growth, unemployment and core inflation, and judge whether the pattern is persistent. Our guide to reading CPI data is a good companion.
Why it matters for traders
Recognising the conditions that can lead to stagflation helps traders understand why markets might behave differently from the usual playbook, with shares and bonds falling together and commodities holding firm. It is a reminder that relationships between assets are not fixed.
If you would like to build a clearer understanding of how economic conditions shape your trading decisions, our free trader assessment is a good place to start and shows where to focus next.
