Stagflation: US experiences

What is stagflation?

The simplest way to think about stagflation is as a sharp contraction of the economy’s ability to produce goods and services at the current price level. In the 1970s and 80s, the causal factors were the massive increases in oil prices in 1974 and 1980. Since the oil price increase was relative to other prices, it could not be offset by economic policy. The result was an unavoidable decline in corporate profits – and therefore in stock prices – and in real wages.

Interpreting US data

Looking first at the 1970s and early 80s, negative (that is, contractionary) aggregate supply shocks depressed real GDP growth in 1974-75 and 1980. These coincide with large increases in oil prices, which rose ten-fold between 1973 and 1980.

The oil price increases also led to increasing inflation in this period. However, since inflation responds much more sluggishly than real GDP growth to shocks, the effects of the different contractionary aggregate supply shocks accumulate and push up inflation for most of the 1970s. Demand also played a role, as illustrated by the demand shocks that were positive in 1976-79 and 1981.

It is interesting to compare the oil price shocks of 1974 and 1980. In 1974-5 the aggregate demand shocks were negative, amplifying the fall in real GDP. In 1980, the aggregate demand shock was also negative, but it turned positive in 1981 as the US authorities adopted expansionary policies. The net effect was to limit the fall in real GDP at the cost of a second surge in inflation. It soon became clear that inflation needed to be contained and tighter macroeconomic policies led to a sharp contraction in demand in 1982 and falling inflation.

Turning to the 1990s, the rapid productivity growth under President Clinton held down inflation. Following the financial crisis in 2008, weak aggregate demand appears to have been the main factor explaining low US inflation.

The Covid-19 pandemic

Redoing the analysis using quarterly data to gain more insight into the pandemic effects, the role of shifts to the aggregate supply and demand schedules in 2021 and the first half of 2021 can be studied in detail.

Real GDP growth (relative to base line)

Inflation (relative to base line)

Our model attributes the collapse of real GDP growth in Q2 2020 and the surge in Q3 to swings in aggregate demand. Indeed, aggregate supply factors appear not to have played much of a role for GDP growth. For inflation, the collapse in aggregate demand in Q2 2020 reduced inflation pressures and has continued to do so since, a contraction of aggregate supply has put increasing pressure on inflation to rise. While still small, this contraction provides some evidence of a stagflationary component of current economic conditions although the situation is very different from the 1970s, not least because of the scale of fiscal stimulus.

Conclusions

The events of the last few quarters are small in comparison to the large and repeated contractionary shocks of the 1970s and 1980s. If the Covid shock leads to a prolonged episode of stagflation, there is little sign of that yet in the data.

But more importantly, in contrast to in the 1970s, central banks now have legal mandates for price stability and explicit targets for inflation. This requires them to act forcefully to ensure that any unavoidable temporary increase in inflation does not become permanent. While inflation is uncomfortably high, and may remain so for some time to come, in the end central banks will act. The real questions are rather what actions they will take to ensure that inflation returns to target, and when they will act.

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