It’s a word that keeps economists up at night: “stagflation.”
The ugly combination of inflation and recession maximizes the pain for consumers and businesses while also leaving policymakers without their usual levers for steering the economy. It creates a crisis that’s more than the sum of its parts, says Kellogg economist Phillip Braun.
“Stagflation is when the economy is stagnant and inflation is rampant,” says Braun, clinical professor of finance at Kellogg. “And the sum of two negatives equals three negatives.”
The United States has been fortunate to avoid stagflation for decades, since the oil shocks of the 1970s. But after fears of stagflation during the COVID recovery abated, they have come roaring back in the wake of military actions in Iran and across the Middle East.
In 2022, Braun was one of the voices downplaying the risk of stagflation. But four years later, he’s more concerned about where the U.S. and global economies are trending.
“Today’s environment is more like the 1970s than four years ago,” Braun says. “The environment is ripe for stagflation with this oil-price shock.”
Gas lines and pocketbook pain
The enduring image of 1970s stagflation is long lines of cars waiting to fill up their tanks. An embargo on Western countries by the Organization of Petroleum Exporting Countries (OPEC) set off a global supply shock and led oil prices to quadruple in less than a year, with effects that reverberated through the entire global economy.
But Braun and other economists believe that it wasn’t the oil crisis that kicked off stagflation in the 1970s—it merely created the conditions for it to occur. Instead, poor monetary-policy decisions made by the U.S. Federal Reserve and other central banks ultimately triggered the stagflationary spiral.
Concerned about the oil shock causing an economic recession, the Fed quickly slashed interest rates. But that only fueled inflation further.
“You had a combination of actually going into the recession because of this supply shock and then the Federal Reserve compounding it, with low interest rates pushing inflation up,” Braun says. “They should not have tried to accommodate the price shock with lower interest rates. They should have taken the pain of the recession and kept interest rates high.”
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The Fed’s influence is complicated by the slow diffusion of its policy changes through the economy, compared with the rapid effects of a price shock. The stagflation of the 1970s illustrated just how bad that timing can be.
“Whenever the Federal Reserve cuts interest rates, there will be a lag until that actually helps in keeping us out of a recession,” Braun says. “What we saw in the 1970s is an oil-price shock pushing the economy into a recession and then the Fed trying to combat that. And since it would take a few quarters or a year for the Federal Reserve’s decision to have an impact, when it does hit, it’s coincidental with the recession.”
Echoes of history
In the early 2020s, as the global economy recovered from the COVID pandemic and its shutdowns and supply-chain issues, anxiety over stagflation resurfaced.
When inflation rapidly rose, critics of the Federal Reserve said that the central bank had held interest rates low for too long, and a recession would throw the U.S. back to the struggles of the 1970s. Then when oil prices spiked at the onset of the Russia–Ukraine war, those worries intensified.
But the recession never came, oil prices calmed, and Braun’s 2022 optimism on avoiding stagflation was confirmed.
Unfortunately, he is not so optimistic today. Economic data released shortly before the Iran conflict began indicated a slowing economy and rising unemployment, “so we might be heading into recession already, even without the oil-price shock,” Braun says. “This could propel us further.”
To assess the risk, Braun is primarily watching two factors: whether oil prices stay elevated for an extended period and how the Federal Reserve responds. At the March meeting of the Federal Open Market Committee (FOMC), the central bank held interest rates steady and signaled that there would be no cuts in the near future.
But with Federal Reserve Chair Jerome Powell’s term expiring in May, the future of U.S. monetary policy is uncertain. There is a risk that the mistakes of the 1970s will be repeated.
“We expect the new chairman of the Federal Reserve to be more accommodative to the demands of the Trump administration,” Braun says. “And in these circumstances, it would be pushing interest rates down in a situation where we don’t want to do that because it will push us into stagflation. So that is problematic.”
Preparing for the worst
Should stagflation hit the United States, there’s not much most of us can do except batten down the hatches, Braun says. Investors, for instance, can look to history for a guide on riding out the storm.
“When you adjust for inflation, stock returns were flat in the 1970s, so there was no real gain on investment portfolios [over the entire decade],” Braun says. “That’s what people need to be concerned about. They need to put their portfolio into assets that are more protected from inflation than otherwise.”
Those “safe” assets include commodities and Treasury Inflation-Protected Securities (TIPS) bonds, which adjust their principal relative to the rate of inflation.
For businesses, the usual recession playbook will be complicated further by elevated prices throughout the supply chain, but without the strong consumer consumption they have enjoyed since the pandemic.
“Businesses have to expect rising prices across the board and reduced demand for their products,” Braun says. “That’s what they need to prepare for.”
And while U.S. consumers may not see long gas lines again—American oil production is at all-time highs and may mitigate the shortages of the past—they can expect to pay more at the pump, and everywhere else, until stagflation ends.
“Don’t let your tank run too dry and be conservative in your budget going forward for a few years,” Braun says.