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Is the UK economy heading for stagflation?

  • Describe the economic conditions in which stagflation happens
  • Learn about the consequences for investors of stagflation
  • Explain the different types of inflation
CPD
Approx.30min
Is the UK economy heading for stagflation?
 Pexels/Anna Shvets

While the talk in markets has been about high inflation in recent weeks, there is an even bigger fear lurking in the background - stagflation.

Due to a combination of high inflation and low growth, many economists are worried that the UK has the conditions for a possible slide into stagnation, which would not prove good news for many sectors of the population.

The only solutions possible in an economy gripped by stagflation, according David Page, head of macroeconomic research at Axa Investment Managers, is to inflict financial pain on some people.

This is not what he would wish to happen, but within the range of possible options open to policymakers attempting to fight such an economic crisis, for whom all of the choices are stark.

Stagflation occurs when the rate of inflation in an economy is much above the target level of 2 per cent, while the level of economic growth remains very low, or even negative.

These economic conditions prevailed in the UK for much of the 1970s.

The UK's economy, buffeted by supply issues due to the pandemic and Brexit, as well as rising wages and rapidly rising demand, arguably has all the ingredients for a period of stagflation, as charts one and two, below, indicate.

 

The problem is the solutions available to policymakers to combat higher inflation would be expected to hurt growth, while the solutions available to boost growth would be deeply inflationary. So only one of the two issues can be fixed, and whichever is chosen, a segment of society will suffer.

 

If a government’s response is to try to combat the anaemic growth rate by increasing spending, then inflation will also rise, hurting the prospects for the economy.

But if the response is to put interest rates up as a way to combat inflation, then the level of growth in the economy would likely fall in line with the rate of price growth. 

Much of the debate in UK and global markets is presently centred on the extent of, and persistence of, the much higher inflation rates investors are grappling with around the world.

This inflation is generally regarded as “Demand pull” inflation, that is, inflation caused by a rise in the level of demand from consumers and companies. This type of inflation is generally positive for economic growth, and expectations around this contributed to the rally in value stocks that began in November 2020. This type of inflation does not directly lead to stagflation.

But the gains made by value equities have begun to fade, as investor sentiment switches from optimism to angst about the potential for economies to grow much more, and the extent to which the present spike in inflation is driven by supply-side factors, known as “cost push” inflation. 

This happens when the cost of bringing goods and services to market rises, forcing prices upwards, even if demand is not rising as swiftly.