3 September 2022

What does stagflation actually mean?

Inflation has hit double figures for the first time in 40 years, while the economy is shrinking.

bank of england inflation stagflation cost of living 2022

The Office for National Statistics announced a surprise rise in inflation to 10.1 per cent in July, up from 9.4 per cent in June – the first time time the measure has hit double figures in 40 years.

The rise has prompted many commentators to suggest we are in stagflation for the first time since the 1970s. But what is it – and how long will it last?

What is stagflation?

Depending on your definition, “stagflation” means a period of low economic growth and high inflation. Based on predictions by the Bank of England, if we’re not there, we’re about to be: earlier this month it said it expects “a fall in GDP over the next year and a marked decline in inflation thereafter”, with a recession beginning in the fourth quarter of this year. “Inflation is high, and it has been rising over the last several months, and the economy’s now shrinking,” says Tony Yates, a former Bank of England economist.

Some definitions of stagflation add another indicator: rising unemployment, which the UK has so far avoided – although that may not continue to be true. Figures published by the Office for National Statistics (ONS) yesterday (16 August) showed the UK unemployment rate edged up 0.1 percentage points in the three months to June, with 1.27 million job vacancies, down about 19,000 from the previous three-month period.

The problem with this definition is that the jobs market has changed in recent years, says Yates. The gig economy, zero-hours contracts and a surge in the number of freelancers means “unemployment isn’t a binary thing, like it used to be”.

So we need to look at other indicators – pay rises, for instance, which are still well behind inflation: figures also published yesterday showed real-terms pay fell at a record 3 per cent between April and June. “It’s a little odd at the moment, because you do have a lot of employers saying there are shortages – they can’t get the workers they want,” says the economist Diane Coyle. “On the other hand, they’re not paying more money to get the workers they want, or improving conditions. And so that speaks to a funny kind of inflexibility in the economy… and prices are going up faster than people’s earnings going up.”

Why is inflation so high?

The Bank of England’s Monetary Policy Committee (MPC) is legally mandated by the government to keep inflation as close to 2 per cent as possible; it does this using interest rates, which affect the demand for money, and quantitative easing (QE), which affects the supply of money.

But a number of external factors have conspired in recent months to cause inflation to spiral: the war in Ukraine has pushed energy prices to record highs, and they are expected to rise even further in the coming months: analysis by Cornwall Insight has indicated that Ofgem will be forced to raise the price cap to £3,582 in October and £4,266 in January, and that it will stay “significantly above” £3,000 for the next 15 months.

The pandemic is also to blame: supply chain difficulties created by rolling lockdowns in China, where many of our goods are produced, have led to production problems in the UK, driving up prices, while staff shortages have driven up wages in certain sectors, such as hospitality.

Should we have known stagflation was coming?

With the benefit of hindsight, says Yates, the MPC could have started tightening monetary policy earlier by raising interest rates, which have been at historic lows since the last recession, and “tapering” its QE programme sooner, but that would have caused other problems in the economy. “We’d have had much weaker real demand, and that would have generated much weaker incomes,” he says.

The government was probably better-placed to prevent this, says Coyle, but it ignored its opportunities. “Governments backtrack on things that need doing, like planning reform, or implementing the review on labour standards, or introducing the bills on audit reform or on digital market competition. So it’s not that policymakers have not known what to do. They just haven’t done it,” she says.

So will stagflation affect my house price?

House prices are beginning to reflect what is happening in the rest of the economy – data published this week showed they dropped 1.3 per cent this month, to an average of £365,173.

Market analysts are cautious to predict a catastrophic drop in prices, partly because whenever something like that threatens, the government jumps in with measures to prevent it – like the pandemic stamp duty holiday. But earlier this year Neal Hudson, a housing market analyst at BuiltPlace, told the Guardian he was “more negative about the prospects for the [housing] market than at any time since the start of the pandemic”.

And how does stagflation end?

The easy answer, says Yates, is that “whatever’s driving energy and food prices” needs to dissipate. In the first instance, that means a resolution to the war in Ukraine. “I suppose the most likely way out is that Ukraine wins, regains control of the territory and starts exporting,” he says. “At that point, we might well not go back to purchasing Russian oil and gas in the same quantities, so that bit of the crisis might not go away. It depends how that gets resolved.”

Coyle says that she doesn’t think there is “one thing” that can solve the cost-of-living crisis, but she adds that the government has “many things already on their menu of options that they could actually go ahead and do”. Implementing the employment bill, which would have addressed many of these problems, would have been a good start, but the government left that out of the Queen’s Speech.

“If you’re concerned about labour quality and labour markets not working properly, then why don’t they just go ahead and implement all the things that were recommended?” asks Coyle. “I’m old enough to remember the late 1970s, and living in a family where incomes did not go up to keep pace with inflation was really tough.”