Stagflation is a combination of the words inflation and stagnation. It talks about conditions in the economy marked by high unemployment and slow growth, that is, stagnation in the economy, combined with increasing prices or inflation. The term was coined nearly fifty years ago. A British politician mentioned this in a speech in the House of Commons. In the beginning, many experts believed this was a condition that was impossible in the national economy. This is because inflation rates and unemployment typically move in the opposite direction. But the great inflation period nearly forty years ago showed that stagflation was a real phenomenon. It should be that the effects of stagflation on the stock markets and the economy could be huge. Some experts think the United States could also experience some signs of stagflation this year because the previous year saw a big reversal in consumer demand and many supply chain issues. This has led to an increase in prices. The invasion of Ukraine by Russia has also led to increasing fuel prices. This is even though the Federal Reserve has started the rate hike campaign. The impact of stagflation is that if it continues, it can lead to escalating declines in the gross domestic product that could cause a recession. In this article, let us learn more about the effects of stagflation on the stock markets and the economy.

Iain Macleod, British Conservative Party politician, has said, "We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation, and history in modern terms is indeed being made." Richard J. DeKaser, executive vice president and chief corporate economist at Wells Fargo & Co, said, "Many things contribute to stagflation, but excess growth in the money supply is most important. During the 1970s, for example, Fed Chairman Arthur Burns responded to soaring commodity prices with inappropriately easy monetary policy that allowed inflation to persist and get firmly entrenched in expectations. The record now shows that, to some degree, this was because he succumbed to political pressure at the time. Stagflation is unambiguously harmful to the economy, as high inflation and inflation uncertainty distort investment decisions. It damages fixed-income markets as rising interest rates push bond prices lower and depress equity valuations."

"The worst part of the experience of the 1970s was the aftermath. A severe recession was required to reverse the momentum of ever-higher inflation (1981-82). It took over a decade to wring out the fears of an inflation resurgence. It wasn't until the 1990s that investors began to seriously discount such a threat. First, if the Federal Reserve is too complacent about inflation, it may let the money supply get too big. Second, if temporarily elevated inflation persists for long — say, two years or more — they may get baked into expectations and lead to a cycle of self-fulfillment."

What is Stagflation vs. Inflation

Inflation and stagflation are terms that are quite related. But they are not the same. The term inflation talks about continued growth in the country's average price levels of these services and goods, not excluding any one kind, in the national economy. Inflation occurs when the money supply increases at a higher rate than the economy can create services and goods. Stagflation occurs when inflation exists with high unemployment and declining economic growth. Usually, these conditions in the economy do not happen together. Inflation and unemployment are inversely correlated. So, as the rates of unemployment increase, inflation usually declines and vice versa. Also, this relationship is not always predictable or stable, as the period of great inflation had shown.

What are Stagflation's Causes? 

The phenomenon is the combined result of some economic ills. These include high costs of services and goods, high rates of unemployment, and the economy's declining growth. The main causes of this economic condition are the monetary and fiscal policies and the supply shocks. Supply shock declines the capacity of the economy to create services and goods at given prices. For instance, there have been many supply shocks in services throughout the coronavirus pandemic because people postponed their healthcare procedures and elective surgeries. In goods, there were shortages of semiconductors, which started even before the pandemic. In labor, there were fewer people in the workforce.

What are the Effects of Stagflation on the Stock Markets? 

The combination of fast inflation, high unemployment rates, and declining growth put great pressure on the nation's economy. For the typical household, this condition means that people are getting less money while spending more on everything, including consumer products, housing, medicine, and food. As the spending in the economy slows down, the corporate revenue also decreases. This leads to a boost in this condition on the nation's economy. Stagflation could also majorly affect international trade by increasing the commodity prices all over the globe for everything, including food. This makes it a lot more costly to do business and thus increases inflation further. Unemployment can also decrease the global economic output, spending, and consumer confidence. This leads to more unemployment in areas because of the interconnectedness of international trade. 

The various national policies that are made to tackle this condition might also have an impact on global trade. This is because these policies create varying conditions for recovery that might conflict. This affects the developing and emerging economies more. This is because several of these nations do not have the capacity to have the type of stimulus or monetary policies that the developed countries use to tackle this condition. This is because of their high deficit-to-GDP ratios. The effects of stagflation on the stock markets are also huge. This condition usually results in lower profit margins. This is because of the lower sales and the higher prices of inputs. This also has a great impact on the financial markets. The S&P 500 in the last half a century has given a return of an average of nearly three percent per quarter. But reports by experts say that the historical returns become negative two percent when there is stagflation in the economy.

The condition can also directly impact the investors by leading to a decline in the growth of firms' earnings per share. This impacts the prices of the shares. The investors of dividends may be negatively affected because the firms suspend or decrease their dividends to conserve their cash. Or the people who are investing in growth stocks, there could be big losses because many people have expected growth targets that are priced into their equities. This condition would make it harder to meet. If the condition happens long enough, some firms might go bankrupt and cause major losses to the investors. The inability of firms to repay their debts is also going to affect the bond prices. But there are several ways investors can hedge against inflation risk. These include the funds that have been created specifically to navigate through the period of high inflation. Investors worried about the effect of stagflation on the stock markets. Their portfolio might like to shift their strategy of investment or stay in blue-chip shares in stable industries with steady earnings and recover quickly by tiding over this condition.

Conclusion

The effects of stagflation on the stock markets and the overall economy of any nation are huge. There are predictions by experts that there might be similar conditions building right now in the United States. The condition has weighed heavily on the nation through the past fifty years. There have been some concerns that it may happen again when the economy returns from the recession induced by the pandemic. The experts are closely watching the new inflation, unemployment, and growth trends along with the potential catalysts that could cause stagflation. This includes central bank policies and disruptions in the supply chain. The high prices of energy have also caused some concern among some experts. The effects of stagflation on the stock markets are yet to be seen this year.