What causes stagflation?

The textbook trigger is a supply shock, such as a sharp rise in energy costs, that pushes prices up while cutting output at the same time. Inflation expectations that become entrenched can keep prices rising even after growth has slowed. Loose policy in the run-up can make both worse.

Is stagflation the same as a recession?

They can overlap without being the same thing. A recession is a broad decline in economic activity, and prices often cool during one. Stagflation adds high inflation to weak growth, so a recession with rising prices would qualify, while a slowdown with calm inflation would not.

What Is Stagflation, and What Does It Do to Stocks?

Q: What Is Stagflation, and What Does It Do to Stocks?

Stagflation is high inflation combined with weak or falling growth and rising unemployment, with the United States in the 1970s as the usual textbook example. For stocks, costs tend to rise faster than prices at companies without pricing power, and returns that look positive can be negative once inflation is taken out.

A 6% return sounds like a gain. If prices rose 8% over the same year, it bought you less than the money you started with.

The statement says up. Your purchasing power says down. That gap is the part of stagflation an investor feels most directly.

Why is stagflation such a bind for policymakers?

Normally inflation and unemployment pull against each other. A hot economy pushes prices up and joblessness down. A cold one does the reverse. The central bank leans against whichever problem is bigger.

Stagflation puts both problems on the same side. Prices rise. Growth weakens. More people lose work. Raising interest rates fights inflation by cooling demand, and cooling demand is exactly what an already weak economy cannot afford, because it means more job losses and less spending; cutting rates to support growth, on the other hand, risks letting inflation run higher and settle into the prices and wage demands people set for the following year. Every tool has a cost.

The United States in the 1970s is the example textbooks reach for, a stretch when high inflation and weak growth ran together for years.

Fiscal policy has its own version of the trap. Extra government spending supports growth. It also adds demand to an economy where prices are already climbing. The split between the two kinds of policy is set out in monetary vs fiscal policy.

What does it do to companies?

Costs arrive first. Energy, materials, freight and wages rise, and each one lands in cost of goods sold or operating expenses. A company that can raise its own prices to match protects its margin. One that cannot absorbs the difference.

Take a hypothetical company whose costs rise 8% while it can lift prices only 4%. Its margin shrinks every quarter the gap lasts, and weak growth compounds the damage, because falling volume leaves the same fixed costs for rent, salaries and equipment spread over fewer sales, so each unit sold carries a heavier load of overhead than it did a year earlier.

Pricing power becomes the dividing line. Necessities tend to hold up better. So do products customers cannot easily replace or do without. Businesses selling discretionary goods to households whose real incomes are shrinking tend to suffer twice: once on cost and again on demand, since squeezed households spend a smaller share of each new dollar on extras. That spending behavior is described in the concept of marginal propensity to consume.

What does it do to stock valuations?

Higher inflation usually brings higher interest rates. Higher rates raise the return investors demand from stocks. That lowers what they will pay today for future earnings, so even if a company’s profit holds steady in dollars, the price investors are willing to pay for each of those dollars can fall.

Add shrinking margins and both parts of a share price come under pressure together. Earnings drop. The multiple drops too.

What can you check in your own holdings?

Look at each company’s gross margin over recent quarters. Held steady while costs rose? It is passing costs on. Slipping? It is not.

Read the earnings call or the management discussion for language about price increases, and then check the volume figures in the following quarters, since a company that raised prices and kept its customers has shown pricing power, while one that raised prices and watched volume fall has found its limit.

Measure your returns in real terms. A portfolio up 6% in a year of 8% inflation has lost purchasing power, and the risk-free rate matters here too, since cash and short Treasuries reprice with rates while fixed coupons do not.

If you carry a margin loan, the squeeze comes from one more side. Margin rates are usually priced off a broker base rate that follows short-term interest rates, so when the central bank raises rates to fight inflation, the cost of the loan climbs in the same months that the real return on the holdings it financed is falling, and a position that cleared its interest cost comfortably can stop doing so. Run the new rate through the margin interest calculator before assuming the old sum still works.

Stagflation can arrive alongside a recession. The two are different conditions. For how a recession is defined and dated, see what a recession is and who decides. The economics section has more on how the wider economy feeds into prices.