Recent Updates

What is Stagflation?

July 9, 2024July 11th, 2024No Comments
Mariel Rhetta
Content Strategist at Rutland FX
Published on: (Updated ) - minute read
With inflation dominating economic discussions and central banks taking action to manage it, you may have heard the term “stagflation” surface. This economic condition poses a unique challenge, combining elements that complicate traditional policy responses. In this article, we’ll explore what stagflation is, why it’s a risk that markets are concerned about, its potential impacts, and what makes it particularly difficult to address.

Need to Manage Your Currency Risk?

Request a CallBack

Rutland FX can help you manage your currency exposure with forward contracts and competitive rates.

What is Stagflation?

Stagflation refers to a situation where an economy experiences slow or no growth in real GDP (Gross Domestic Product) while simultaneously facing high inflation. This unusual combination creates a conundrum for economic policy because measures to combat inflation often exacerbate stagnation, and vice versa. Unlike typical economic scenarios that involve either inflation or stagnation, stagflation combines the worst of both worlds, making it a particularly challenging economic condition to address.

The term "stagflation" became widely known during the 1970s when many economies, particularly the United States and the United Kingdom, faced high inflation, slow growth, and rising unemployment. A key trigger was the 1973 oil crisis, when oil prices quadrupled due to an embargo by the Organization of Arab Petroleum Exporting Countries (OAPEC). This spike in energy costs led to higher prices and economic slowdown, creating the perfect storm for stagflation.

Is the UK Experiencing Stagflation?

The latest GDP data released by the Office for National Statistics shows that real GDP in Q1 2024 grew year-on-year by 0.3%. This modest growth, combined with the fact that headline inflation in the UK is now at 2%, suggests that the UK is not currently experiencing stagflation. However, economic conditions are dynamic and can change over time.

Why is Stagflation a Risk?

Stagflation is a significant risk because it creates a challenging environment where conventional monetary tools may not work as they usually do. Typically, central banks use monetary policy levers, such as adjusting interest rates, to manage economic conditions. However, in a stagflation scenario, these tools can become ineffective or even counterproductive.

For example, consider an economy with 4% inflation, while the target inflation rate is 2%, and there is negative GDP growth. In normal circumstances, if the economy were experiencing slow growth, the central bank would lower interest rates to stimulate economic activity. Lower interest rates reduce the cost of borrowing, encouraging both consumers and businesses to spend and invest more, thereby boosting growth.

However, in a stagflation situation, lowering interest rates could exacerbate the problem. With inflation already above the target rate, reducing interest rates further could lead to even higher inflation. The increased money supply from lower interest rates might not necessarily lead to increased production or economic growth but could instead fuel more price increases, making inflation worse.

Stagflation’s Impact on Currency

Stagflation can have a profound impact on a country’s currency, influencing its value and stability in several ways. There are numerous implications for stagflation on an economy’s currency; here are just a few key points:

Currency Depreciation:
  • Stagflation often leads to currency depreciation.
  • As inflation rises and economic growth stagnates, investor confidence in the economy can wane.
  • This lack of confidence can result in capital outflows and reduced demand for the country’s currency, causing its value to fall in foreign exchange markets.
Increased Volatility:
  • Currencies in stagflationary economies tend to experience increased volatility.
  • The combination of high inflation, slow growth, and unpredictable policy responses can lead to erratic currency movements.
  • As markets are forward-looking, they will be trying to price in future expectations, which is difficult to do in a stagflation environment.
  • This increased volatility often results in a weaker currency as people de-risk their portfolios, making it challenging for businesses and investors to plan and manage currency risk effectively.

Stagflation, a challenging mix of high inflation and low or no GDP growth, complicates traditional policy responses. While the UK currently shows modest GDP growth and stable inflation, the risk remains. Stagflation makes conventional monetary tools less effective, requiring careful navigation by policymakers. Understanding and preparing for stagflation is crucial for maintaining economic stability.

Still not sure?

If you are still unsure or have any further questions, please call us on 0203 026 0112 or request a callback to discuss your requirements.