What is stagflation, and how might policymakers prevent it?

The US economy shrank in the first quarter of 2025.¹ (It had been growing since 2022.) Inflation ticked down in March,² while unemployment remained essentially flat.³ The confluence of a stagnating economy and the potential for rising inflation has brought stagflation fears back into the public conversation. To be clear, we’re not in a stagflationary environment, but concerns about it have been rising. So, what is stagflation, and how might policymakers deal with it?

What is stagflation?

Stagflation is a mashup of the words “stagnation” and “inflation.” Likely coined by British politician Iain Macleod in the 1960s, the term describes the combination of a flat or shrinking economy with elevated unemployment and high inflation. Stagflation took hold in the 1970s when a stagnant US economy saw oil prices skyrocket, fueling inflation across the economy.

This unique economic climate can prove devastating to consumers and businesses and difficult to deal with for governments.

Stagnating economy

When an economy slows or stops growing, consumers and businesses tend to spend less. Consumers typically buy fewer things and delay large expenses. Businesses often make fewer capital improvements and avoid hiring new staff. Stagnation is a normal part of the business cycle, and while not preferable, won’t necessarily lead to stagflation on its own.

High inflation

A stagnating economy tends to have low inflation given the pullback on spending. But this doesn’t always happen. If conditions are right, inflation can sometimes rise. Rising prices push up the cost of living. And adding high inflation to economic stagnation raises the potential for stagflation.

High unemployment

The third condition is high unemployment which exacerbates the economic stagnation. Fewer consumers have jobs, and those who do may not feel as comfortable in them. Wages may not keep pace with rising prices, which erodes purchasing power.

What can cause stagflation?

A slow-growing economy tends to have low inflation. But with stagflation, the traditional rules of economics don’t seem to apply. Certain conditions can give rise to or exacerbate a stagflationary environment.

Supply shocks

Supply shocks refer to a sudden disruption in the availability of key goods and resources. Drastic price increases tend to get passed along to the buyer which can push up inflation. The economy struggles to grow under the additional weight placed on consumers and businesses.

Monetary policy errors

The Federal Reserve (Fed) manages monetary policy to keep prices stable and unemployment low. This difficult balancing act can contribute to stagflation if mismanaged.

Regulatory and tax changes

In certain circumstances, regulatory and tax changes can help push an economy into stagflation. New regulations can increase the cost of doing business, while higher taxes reduce disposable income. Both can dampen economic activity. While these changes may be necessary in the moment, they can inadvertently lead to stagflation if not carefully balanced.

Global economic influences

No economy exists in a vacuum. Global economic factors can contribute to stagflation in many ways.

• Supply chain disruptions may drive up prices on materials used to build certain products. These costs are often passed along to consumers creating inflationary pressure.
• Global energy prices are subject to international market dynamics. Conflicts in oil-producing areas can increase transportation costs, prices and ultimately inflation.
• Currency fluctuations can weaken a country’s currency compared to others. More expensive imports can make inflation worse.

How can policymakers fight stagflation?

Stagflation can be challenging for policymakers. Fighting inflation by raising interest rates risks holding back the economy, which contributes to stagnation. Stimulating the economy by lowering interest rates risks raising prices, which contributes to inflation. How might policymakers boost growth, tame inflation, and reduce unemployment at the same time?

Monetary policy adjustments

The Fed has a few tools at its disposal. The trick is to spur spending and investment without driving up prices. Tweaks to the interest rate can help, along with targeted liquidity measures, such as low-interest loans in certain sectors. Quantitative easing — buying government securities to boost the money supply and encourage investment — is another approach.

Targeted fiscal policies

The government can help address stagflation with fiscal policies aimed at the root causes. Targeted tax cuts could incentivize companies to hire. Consumer support through social benefits may help consumers redirect spending and lift the economy.

Supply-side reforms

The government might attack inflation with efforts to enhance productivity and reduce costs for businesses. Improved infrastructure and streamlined regulations, for example, could help businesses operate more efficiently and keep prices down.

Energy and resource management

Global energy prices can factor into stagflation. To counter this risk, the government might consider investing in alternative energy sources and improving energy efficiency.

International cooperation

Stagflation can grow out of global issues. So, maintaining cooperative relationships across borders can help resolve trade disputes, stabilize currency markets, and maintain supply chains.

How can stagflation affect investors?

Consumers tend to face higher prices at the register, not to mention job instability, which may lead them to reconsider spending in the first place. Saving money becomes more difficult. Investors may face multiple challenges.

Inflation erodes returns

In a stagflationary environment, inflation eats away at the purchasing power of money. That reduces an investment’s real returns. Bonds and other fixed income investments can be particularly vulnerable if interest payments don’t keep pace with rising prices.

Stock market volatility

When stagflation sets in, companies may face higher costs and slower growth, which can squeeze profit margins and lead to uncertain earnings. This uncertainty can lead to volatile stock prices if investors sell due to market fears.

Sector-specific impacts

Various economic sectors react differently to stagflation. Consumer goods companies might struggle as higher prices prompt consumers to dial back spending, while the energy sector could benefit from rising commodity prices. Technology may face issues if businesses and consumers delay purchases, though cost-saving solutions and essential services may present opportunities.

How might investors help guard portfolios during stagflation?

Investors should be strategic when navigating a stagflationary environment.

Diversification

By spreading investments across various asset classes, sectors, and geographies, investors can help reduce risk and possibly increase the chances of finding pockets of growth. The mix might include stocks, bonds, commodities, and real estate.

Hedging

Hedging strategies may help safeguard portfolios from the adverse effects of inflation. Inflation-protected securities, which are designed to increase in value with inflation, help maintain purchasing power. Gold, silver, oil, and other commodities generally do well in inflationary times, as their prices tend to rise with increasing costs.

Focus on quality and value

High-quality companies with strong balance sheets and consistent cash flows are typically better equipped to weather an economic storm. Value investing — finding undervalued stocks with solid fundamentals — may also be a viable strategy.

Defensive posture

Certain sectors, like health care, utilities, and consumer staples, are less sensitive to economic cycles. Companies in these defensive sectors tend to have more stable demand often leading to a more reliable revenue stream during stagflation.