What is Stagflation: Causes, Effects, and How to Manage it | Espresso


What is stagflation?

June 30, 2022
What is stagflation?

Stagflation is a combination of two economic principles – stagnation and inflation. It occurs when economic activity drastically slows down resulting in no economic growth, while prices of basic commodities continue to rise due to supply chain constraints. The phenomenon is particularly harmful, as it affects the demand as well as the supply sides – there is lesser money for consumers to spend and the money is quickly losing its value too. 

Imagine you’re a small company that is not seeing any revenue growth YoY. Now your biggest raw material supplier comes in and tells you that he must increase prices by 15%, as he cannot afford to supply at previous year’s prices anymore. Simultaneously, your employees come in and ask for a raise, as the cost of essentials just went up substantially. This is your business facing stagflation pressure, which will directly affect your bottom line for the year. 

Is the world heading into stagflation? 

 In the aftermath of the covid-19 pandemic, the USA pumped in roughly $5tn into the money supply, to help ailing businesses survive. With that much additional money available, prices of everything started to slowly creep up throughout 2021 and the Russia-Ukraine war just pushed things over the edge in early 2022. The US inflation rate for May 2022 was 8.6%, a number not seen since December 1981. The Federal Reserve was then forced to raise interest rates, to combat this rampant inflation, with 50 and 75 bps hikes in May & June 2022 respectively. 

So, to answer the question – yes certain parts of the world are at risk of going into stagflation. Unless something radical is done world over to spur economic activity, there are countries where there is a high probability of stagflation. These are classified into two major buckets: 

  • The ones that cannot show much economic growth i.e developed nations 
  • The ones that cannot afford economic growth i.e underdeveloped nations  

India, thankfully, falls in neither of the above categories. Despite posting inflation numbers of 6.95% in March of 2022, its highest since October 2020, the country is still poised to grow at 6.4% in 2022. This may be slower than what was originally expected, but it’s growth nonetheless. Growth which most parts of the world are unable to find at the moment.  

How to combat stagflation? 

Now that we know what stagflation is, here are some of the steps that governments and central banks can take to combat the risks of stagflation, in case they find themselves in such a scenario:

Reduce dependency on oil:

The major pressure economies face on rising input costs, comes from the rising price of oil. Hence, with EV policies coming in world over, there is a plan to slowly move away from the overarching dependency on oil that countries have.

Spur economic activity through government spending:

John Maynar Keynes, in 1930 suggested that “governments should pay people to dig holes in the ground and then fill them up”. Even though this sounds silly,what he meant to say was that governments should spend money to build infrastructure, which can be used to put money in people’s hands, which can spur economic growth.

Focus on supply side constraints:

Once the supply side constraints are deal with, prices automatically go back to equilibrium, which causes demand to pickup again e.g India planning to invest $100Bn over the next 5 years in the semiconductor space, to combat the woes of the last 12-18 months.

Stagflation, if not dealt with, can be a cause of massive concern for countries. However, with enough monetary and fiscal tools at their disposal, governments and central banks possess enough ammunition to nip it in the bud and prevent its effects reaching the common man. 

Also read about RBI Monetary Policy.

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R. Kalyanaraman
by R. Kalyanaraman

Chief Executive Officer

I am a sales guy at heart with utmost willingness to listen to people – customers, employees, competitors et al. Nothing gets me a bigger adrenaline rush than an interesting conversation with my customer!