What is stagflation and can it lead to a recession?

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The opening to Lady Thatcher to seize the top role in politics was provided by the stagflation crisis of the mid-1970s, when Britain experienced a lethal combination of slow growth and high inflation. Photo: PA
The opening to Lady Thatcher to seize the top role in politics was provided by the stagflation crisis of the mid-1970s, when Britain experienced a lethal combination of slow growth and high inflation. Photo: PA

A chorus of economists have been ringing the alarm for months about a looming stagflation as prices skyrocket, incomes fall and consumers reign in spending following a surge in the cost of living.

Inflation has recently become a major issue for the first time in decades amid the tightest squeeze on household budgets since the 1970s.

The World Bank warned of a "considerable danger of stagflation" after slashing the 2022 global economic outlook to 2.9% from the 4.1% forecast in January. It expanded 5.7% last year despite setbacks from the coronavirus crisis.

Additionally, lengthy COVID lockdowns in China and Russia's invasion of Ukraine have deepened supply chain issues, which were just starting to recover from the pandemic havoc.

This has caused price volatility and global growth to nosedive, mounting fears of major developed economies entering recession.

Read more: UK on brink of recession amid warning of weakest economic growth of developed world

"The war in Ukraine, lockdowns in China, supply-chain disruptions, and the risk of stagflation are hammering growth," World Bank president David Malpass said. "For many countries, recession will be hard to avoid."

Britain already has skyrocketing inflation, rising unemployment and a slowing economy that is forecasts to flatline in the coming months. As it battles on all fronts could stagflation be next and cause a recession?

What is stagflation?

Stagflation is a play on words, combining stagnation and inflation and was made popular during the recession in the 1960s and 70s.

The term was first coined by former chancellor of the exchequer Iain Macleod during a speech on the UK economy in the House of Commons in November 1965.

"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," Macleod stated. "We have a sort of stagflation situation."

The periods most associated with the phenomenon include the oil crisis in 1973-1975 and the decline of traditional British industries that lasted into the 80s.

It was this lethal combination of slow growth and high inflation that provided former prime minister Margaret Thatcher the opportunity to seize the top role in politics.

Watch: What is a recession and how do we spot one?

Is stagflation happening now and can it lead to a recession?

Britain's current juncture resembles the past in three key aspects: soaring inflation; low or stagnant economic growth; and high unemployment which could send the economy back in time.

Much like the 70s, energy prices have also soared to record highs, jumping as much as $139 a barrel after the invasion of Ukraine, fuelling a knock-on rise in household energy and fuel costs.

Despite the £15bn of extra support provided by chancellor Rishi Sunak to help with energy bills, the chances of the UK entering a recession – two successive quarters of negative growth – have increased.

Britain is on the brink of recession, according to the Organisation for Economic Co-operation and Development.

The Paris-based group warned economic headwinds including inflation and staff shortages will derail the pandemic recovery and grind the economy to a halt. It forecast an expansion of 3.6% this year, the second-fastest rate in the G7, before sinking to zero – the weakest economic growth in the developed world.

Economists caution the combination of aggressive interest rates hikes to curb inflation could trigger a recession.

"Ultimately, the risk is that the combination of the energy price shock and rising interest rates leaves the UK in recession, having only just climbed back to pre-pandemic levels of economic activity," said Laith Khalaf, head of investment analysis at AJ Bell.

UK food prices rose from 6.7% to a 13-year high of 8.5% in May. Photo: Matthew Horwood/Getty
UK food prices rose from 6.7% to a 13-year high of 8.5% in May. Photo: Matthew Horwood/Getty

Inflation

In the UK, inflation hit a fresh 40-year high of 9.1% in May, nearly five times the Bank of England’s 2% target, driven by higher fuel and food prices, and the energy price cap jump.

Prices rose 0.7% in the month alone, a slowdown from the 2.5% pace recorded in April when the 54% energy cap came into effect.

The Office for National Statistics said food prices rose from 6.7% to a 13-year high of 8.5%. The 12-month rate for motor fuels was 32.8%, the highest since before the start of the data series in January 1989.

Read more: UK inflation hits fresh 40-year high of 9.1%

Consumer prices are now on course to peak above 11% in October, according to the Bank's revised forecast.

But analyses by think tanks already point to UK's poorest households facing nearly 11% inflation, which could rise further if prices continue to soar.

This negative outlook reflects a combination of surging inflation, weak business investment, tax rises and the global economic shocks – initially caused by COVID and then compounded by the Ukraine war.

UK historic inflation rate. Chart: PA Graphics
UK historic inflation rate. Chart: PA Graphics

Interest rates

The BoE is tasked with balancing hiking rates to tame inflation without pushing the country into recession.

It has maintained an aggressive campaign to tackle rampant inflation, increasing interest rates for the fifth consecutive time in June, from 1% to 1.25%, with calls for more aggressive hikes.

Rates are now at their highest level since January 2009, when they were hiked during the recession that was caused by the 2008 financial crash.

BoE's chief economist Huw Pill has signalled more increases are on the horizon if inflation shows signs of becoming a permanent feature of the UK's economy.

However, analysts warn Threadneedle Street's efforts to tame prices could tip Britain into a recession.

Tom Stevenson at Fidelity International, said: "The Bank of England is battling a toxic combination of high inflation and stagnant growth. It means policymakers are pulled in two opposing directions, an impossible balancing act for rate-setters.

"Rates look likely to rise to 3% next year but, while this may take the heat out of inflation, it will come at a heavy cost. A recession looks increasingly likely."

UK interest rates.
UK interest rates.

GDP

The BoE expects the economy to contract further in the current quarter. Gross domestic product (GDP) is now anticipated to drop by 0.3% across the quarter, weaker than previous expectations.

Separate figures from the ONS show GDP shrank 0.3% in April as businesses felt the impact of price rises and supply chain disruption.

Read more: UK economy shrinks in April as households struggle against cost of living

The scaling back in NHS COVID-19 testing and vaccinations, which shaved 0.5 percentage points off growth, was the main driver of the contraction.

For the first time since the lockdown of January 2021, all the main components of GDP, services, manufacturing and construction fell, negatively contributing to the monthly figure.

UK monthly economic growth. Infographic: PA Graphics
UK monthly economic growth. Infographic: PA Graphics

Labour market

Some firms have sought to offset the damage, at least in part, with wage increases driven by high demand for workers, sparking fears of a wage spiral.

The threat of a wage spiral, a major component of stagflation in the 70s and 80s, is so real that BoE governor Andrew Bailey urged workers to limit their pay bargaining to prevent it from happening.

Prime minister Boris Johnson warned: "When a wage-price spiral begins, there is only one cure, and that is to slam the brakes on rising prices with higher interest rates."

Pay growth versus inflation. Chart: PA Graphics
Pay growth versus inflation. Chart: PA Graphics

UK wages fell at the fastest pace in more than two decades in April as pay packets failed to keep pace with soaring prices.

Figures from the ONS show adjusted for inflation pay, excluding bonuses fell 3.4% year-on-year — the biggest decline since records began in 2001.

Read more: UK real wages fall to 20-year low as job vacancies rise to 1.3 million

Real-terms income fell 2.2% between February and April. This was the biggest fall since 2011 as workers grapple with the cost of living squeeze as inflation eats away at pay increases.

At the same time unemployment rose to 3.8% during the period, as more people look for work. That’s up from 3.7% in the quarter to March, which was the lowest in 50 years.

Watch: How does inflation affect interest rates?

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