Stagflation

What Is Stagflation?

Stagflation is the unusual and painful combination of high inflation together with high unemployment and stagnant economic growth. The term blends "stagnation" and "inflation," and it describes a situation that standard economic thinking once considered unlikely, since inflation and unemployment were often assumed to move in opposite directions. The classic example is the United States in the 1970s, when oil shocks and other pressures drove prices sharply higher even as growth faltered and joblessness rose. Stagflation is especially difficult for a central bank because the two halves of the problem call for opposite responses under its dual mandate.

Why It Matters

Stagflation poses the hardest possible dilemma for the Fed. Fighting the inflation half calls for raising rates, but that risks worsening the unemployment half; supporting jobs calls for cutting rates, but that risks fueling inflation further. The 1970s episode shaped modern central banking: it discredited the idea that policymakers could simply trade a little more inflation for lower unemployment, and it set the stage for Paul Volcker's aggressive rate hikes to break inflation at the cost of a deep recession. The experience also helped prompt Congress to emphasize maximum employment in the Fed's mandate and made price stability a lasting priority for policymakers determined not to repeat it.

Test Your Knowledge

Questions on this topic from the EconRecall fact bank:

• What term describes the unusual combination of high inflation and high unemployment/stagnant growth, seen in the 1970s?
  Stagflation
• What historic economic event prompted Congress to formally add "maximum employment" to the Fed's mandate via the 1978 Humphrey-Hawkins Act era legislation?
  The stagflation and high unemployment of the 1970s