Why stagflation is theoretically puzzling
Traditional macroeconomic theory, embodied in the Phillips Curve, suggested a trade-off between inflation and unemployment: lower unemployment came with higher inflation, and higher unemployment with lower inflation. Policymakers could choose their preferred point on this curve. Stagflation violated this framework entirely — it demonstrated that high inflation and high unemployment could coexist. The theoretical explanation: the Phillips Curve trade-off holds for demand-side shocks (stimulus causes growth and inflation, recession causes deflation and unemployment). But supply-side shocks (oil prices rising, supply chain disruptions) can simultaneously raise prices and reduce output — causing both inflation and unemployment at the same time.
The 1970s experience and the Volcker shock
The 1970s stagflation arose from twin oil shocks (1973 OPEC embargo, 1979 Iranian Revolution) combined with expansionary fiscal policy and loose monetary policy that had allowed inflation expectations to become entrenched. In the UK, inflation peaked above 25% in 1975 with unemployment also rising sharply. The eventual cure — engineered by Fed Chairman Paul Volcker in the US and broadly echoed in the UK — was deliberately tight monetary policy that raised real interest rates sharply. The Volcker shock of 1980–1982 caused a severe recession (US unemployment above 10%) but broke the back of inflation expectations. The lesson: supply-side stagflation may require accepting a severe demand contraction to restore price stability — there is no painless solution.
What this means for you
The 2021–2023 period exhibited mild stagflationary characteristics in many developed economies — supply chain disruptions from COVID combined with energy price shocks from the Ukraine war raised inflation while slowing growth. Central banks ultimately chose to raise rates aggressively to address inflation, accepting slower growth as the lesser evil. For investors, genuine stagflation is one of the worst environments: equities suffer from weak earnings and higher discount rates; bonds suffer from rising rates and inflation; cash loses purchasing power to inflation. Historically, commodities (oil, gold, agricultural products) and index-linked bonds have provided the best protection during inflationary supply shocks — the core assets of an inflation-resilient portfolio.