Understanding Stagflation and the Risk of Its Recurrence
Understanding Stagflation and the Risk of
March 31, 2008
Brian W. Cashell and Marc Labonte
Specialists in Macroeconomic Policy
Government and Finance Division
Understanding Stagflation and the Risk of
The slowing of economic growth and the rising rate of inflation in early 2008
have given rise to concerns that the U.S. economy is at risk of an episode of
stagflation. Stagflation describes an economy that is characterized by high rates of
both unemployment and inflation. The term came into popular use in the 1970s to
describe the economy at that time. The unemployment rate reached 9.0% in May
1975 and a high of 10.8% in November 1982. The rate of consumer price inflation
reached 12.2% for the 12-month period ending in November 1974, and 14.6% for the
12-month period ending in May 1980. Inflation is currently about 4% and the
unemployment rate is near 5%, both well below the rates in the 1970s that were cause
for alarm. Nonetheless, higher oil prices and turmoil in financial markets have led
some to warn that stagflation may be in our future.
The key to understanding the nature of stagflation is the natural rate of
unemployment. That is the lowest rate of unemployment consistent with a stable rate
of inflation. Below that rate, inflation tends to accelerate. In the view of the natural
rate model, unemployment and inflation rates may be relatively high at the same
time, and they may even rise simultaneously for a time, particularly if inflation and
the natural rate of unemployment are rising at the same time. What is unlikely to
happen, however, is for the unemployment rate to be high and for the inflation rate
to continue accelerating. If the unemployment rate is above the natural rate, then
cooling labor and product markets would be likely to reduce upward pressure on
wages and prices.
Stagflation in the 1970s coincided with two large “oil shocks.” A large increase
in the price of oil can have macroeconomic consequences in terms of higher inflation,
higher unemployment, and lower output. Both the inflation and output effects of
energy shocks are temporary, however. Once prices adjust, the economy returns to
full employment and its sustainable growth path. It is not the level of energy prices
that affects economic growth and inflation, but rather the change in energy prices.
Thus, if policymakers are concerned with the effect of energy prices on output and
inflation, they should focus more on rising energy prices than “high” energy prices,
even if the high prices are permanent.
Although stagflation is understood to be high rates of both inflation and
unemployment, it is not clear how high those rates have to be to merit the
designation. Whether or not rates less than those observed in the 1970s constitute
stagflation may be a subjective matter. Recent unemployment and inflation rates are
not nearly as high as they were in the 1970s. Some economists, however, fear that the
recent expansion in monetary and fiscal policy, at a time when unemployment is low
but rising and energy prices are rising, could lead to a new bout of stagflation in the
near future. Although policy may not be able to prevent episodes of stagflation from
occurring, there may be enough understanding of the underlying causes to avoid
making conditions substantially worse.
The Prevailing View Before the Stagflation of the 1970s ..............2
The Lesson of the 1970s........................................3
Is Stagflation a Trap?...........................................6
What is the Natural Rate of Unemployment?........................7
Supply Shocks: The Effects of Oil Prices...........................7
Is Stagflation Caused by Oil Price Shocks or Monetary Policy?.....11
List of Figures
Figure 1. Inflation and Unemployment, 1960 to 1969......................3
Figure 2. Inflation and Unemployment, 1970 to 1982......................4
Figure 3. Real Price of U.S. Crude Oil Imports and Recessions, 1971-2003...13
Understanding Stagflation and the Risk of
The slowing of economic growth and the rising rate of inflation in early 2008
have given rise to concerns that the U.S. economy is at risk of an episode of
stagflation. In the best of times, policymakers hope to keep both the unemployment
rates and inflation rates as low as possible. Stagflation, in contrast, may be the worst
of times. Stagflation describes an economy that is characterized by high rates of both
unemployment and inflation.
Stagflation is a term that came into popular use in the 1970s to describe the
economy at that time. The unemployment rate reached 9.0% in May 1975 and a high
of 10.8% in November 1982. The rate of consumer price inflation reached 12.2% for
the 12-month period ending in November 1974, and 14.6% for the 12-month period
ending in May 1980. Many observers also associate this period of stagflation with
large oil price shocks, and some draw another parallel with the recent rise in oil
Inflation is currently about 4% and the unemployment rate is near 5%, both well
below the rates that caused alarm in the 1970s. Nonetheless, higher oil prices and
turmoil in financial markets have led some to warn that stagflation may be in our
The reason stagflation elicits particular concern is that it presents a policy
dilemma in that it may be difficult to find a way to reduce inflation and
unemployment at the same time. Typically, inflation is seen as the result of growth
in aggregate demand outpacing growth in supply, and a contractionary policy would
seem appropriate to bring it under control. Rising rates of unemployment tend to
result when demand growth falls short of growth in supply and so a stimulative
policy might be called for. The policy dilemma arises because the two approaches
There are two views of stagflation. One is that it is the result of economic
policy errors. The other view is that it is the result of external supply shocks, such
as oil price increases, which may be beyond the influence of economic policy.
Understanding what stagflation is requires an explanation of the nature of the
relationship between inflation and unemployment. This report discusses that
relationship in order to provide some understanding of the policy problems. In doing
so, it examines the U.S. experience with stagflation in the 1970s. It also examines
1 See, for example, Graham Bowley, “That ‘70s Look: Stagflation,” The New York Times,
Feb. 21, 2008, p. C1.
some of the research that has been done on the relationship between oil prices and
The Prevailing View Before the Stagflation of the 1970s
The experience of the 1970s had much to do with changing the prevailing view
of the relationship between inflation and unemployment. Prior to that, it was widely
believed that inflation and unemployment were unlikely to trend either up or down
together simultaneously. Rather, it was thought that there was a trade-off between
the two and that they were more likely to move in opposite directions.
In a famous article published in 1958, economist A.W. Phillips claimed to have
found evidence of an inverse relationship between the rate of increase in wages and
the rate of unemployment. Comparing rates of increase in wages with unemployment
rates in Britain between 1861 and 1957, Phillips found that as the labor market
tightened, and the unemployment rate fell, money wages tended to rise more rapidly.2
Because wage increases are closely correlated with price increases, that relationship
was widely interpreted as a trade-off between inflation and unemployment.3 The
implication was that policymakers could maintain lower rates of unemployment by
tolerating rates of inflation. It also implied straightforward policy implications for
either macroeconomic problem — high unemployment could be eliminated through
expansionary monetary or fiscal policy, and high inflation could be eliminated
through contractionary policy.
The curve describing this trade-off became known as the “Phillips curve.” A
stable Phillips curve would mean that policymakers might choose the combination
of inflation and unemployment rates that seemed most palatable and set it as the goal
of macroeconomic policy. The U.S. experience of the 1960s seemed to provide
evidence for the existence of such a trade-off and encouraged those who held this
Figure 1 plots annual U.S. civilian unemployment and consumer price inflation
rates together for the 1960s. These data suggested that there was a trade-off for the
United States, and that policymakers could choose from among a number of
combinations of unemployment and inflation rates, depending on their relative
distastes for the two.
2 A.W. Phillips, “The Relationship between Unemployment and the Rate of Change of
Money Wages in the United Kingdom, 1861-1957, Economica, Nov. 1958.
3 The difference between wage increases and price increases is largely accounted for by
changes in labor productivity.
Figure 1. Inflation and Unemployment, 1960 to 1969
Source: Department of Labor, Bureau of Labor Statistics.
The theoretical explanation for the downward-sloping line describing the trade-
off relied on the simple relationship between supply and demand. As long as
aggregate demand is growing more rapidly than the economy’s capacity to produce,
the unemployment rate will tend to fall, and vice versa. Furthermore, demand in
excess of supply will tend to push up both wages and prices, so that rising prices tend4
to be correlated with falling unemployment.
The Lesson of the 1970s
The experience of the 1970s led to the widespread dismissal of the view that
there was an exploitable trade-off between inflation and unemployment. Much of the
1970s was characterized by simultaneous increases in inflation and unemployment
rates. The phenomenon came to be known as “stagflation,” because of sluggish rates
of growth which led to rising unemployment rates and accelerating inflation. It
became evident that policymakers did not have the option of settling for a higher rate
of inflation in exchange for a lower rate of unemployment.
Figure 2 shows what happened to the relationship between the civilian
unemployment rate and consumer price inflation beginning in 1970. It seems clear
that any trade-off that may have existed during the 1960s, as was shown in Figure
4 See Richard G. Lipsey, “The Relation Between Unemployment and the Rate of Change
of Money Wages in the United Kingdom, 1862-1957: A Further Analysis,” Economica,
Feb. 1960, pp.1-31.
Figure 2. Inflation and Unemployment, 1970 to 1982
Source: Department of Labor, Bureau of Labor Statistics.
As it happens, this breakdown in the apparent trade-off between inflation and
unemployment was anticipated. In the late 1960s, two economists, Milton Friedman
and Edmund Phelps, suggested that there had to be more to it than a simple trade-off
between inflation and unemployment. They predicted a breakdown of the Phillips
curve. They argued that while monetary or fiscal policy might be conducted in such
a way as to realize a particular combination of unemployment and inflation in the5
short run, it would not necessarily be a sustainable combination.
This new argument contended that the trade-off along the Phillips curve was
dependent on the fact that unexpected increases in the price level would reduce real
wages. A reduction in real wages would tend to increase the demand for labor, and
push down the unemployment rate. A rise in prices could still result in lower
unemployment as Phillips had suggested, but only until workers realized that the
purchasing power of their wages was falling. This new view argued that there was
not just a single Phillips curve, but a unique Phillips curve for every different
possible expectation of inflation.
5 See Milton Friedman, “The Role of Monetary Policy,” The American Economic Review,
vol. 57, no. 1, Mar. 1968, pp. 1-17. Also, Edmund Phelps, “Phillips Curve, Expectations
of Inflation and Optimal Employment Over Time,” Economica, Aug. 1967, pp. 254-281.
An unexpected increase in the rate of inflation would, temporarily, reduce the
rate of increase in real wages and contribute to a decrease in the unemployment rate.
A faster rate of inflation causes workers to underestimate the effects of rising prices
on their money wages, and unemployment declines due to a fall in real wages. But,
unless workers never catch on (an unlikely prospect), at some point they will adjust
their wage demands to reflect the higher rate of inflation. This increase in real wage
demands will tend to reverse the drop in the unemployment rate due to the inflation
surprise. In the long run, in this model, the unemployment rate tends toward a level
that represents an equilibrium between the supply of labor and demand for it. This
level was dubbed the “natural” rate, and it is the rate of unemployment consistent
with a stable rate of inflation.6 If the inflation rate is zero, then the natural rate is also
the unemployment rate consistent with a stable price level.7
In the absence of deliberate policy changes, wage adjustments would always be
working to move the economy to its natural rate of unemployment — either from a
higher rate or a lower one. Depending on the conduct of economic policy, however,
the adjustment to the natural rate can either be assisted or hindered.
According to the natural rate model, fiscal or monetary policy may shift the
economy from one point to another along the original Phillips curve only as long as
workers fail to appreciate changes in the price level or the rate of inflation. A higher
rate of inflation would not mean a permanent decline in the unemployment rate.
Eventually, other things being equal, expectations would adjust and the
unemployment rate would tend to return to its natural rate.
If policy attempted to push unemployment below the natural rate, the rate of
inflation would wind up permanently higher after workers raised their expectation of
inflation, and there would be a new trade-off consistent with that higher expected rate
of inflation. Any short-term trade-off between inflation and unemployment would
now involve higher rates of inflation than before. This process of shifting the trade-
off could continue as long as policymakers keep trying to push the unemployment
rate below its natural level. (As discussed below, policymakers can choose a short-
term trade-off only if the natural rate can be accurately estimated.)
For example, suppose that the unemployment rate is 5% and the inflation rate
is 3%. In addition suppose that workers are fully aware of the inflation rate and fully
expect that their wages will increase at the same rate.8 Now suppose that policy
seeks to lower the unemployment rate by tolerating a more rapid rate of inflation.
Say the inflation rate rises to 5%, which means that nominal wages that are rising at
a 3% rate are falling at a 2% rate, in real terms. Those falling real wages increase the
6 The term ‘natural rate’ was originally applied, in a similar way, to interest rates by turn-of-
the-century economist Knut Wicksell. See M. Blaug, Economic Theory in Retrospect
(Homewood, IL: Richard D. Irwin, Inc., 1962), pp. 562-563.
7 Some economists use a more clinical term for the natural rate, the “non-accelerating
inflation rate of unemployment,” or NAIRU. At times, the natural rate is more casually
referred to as the full-employment rate of unemployment.
8 For clarity and simplicity, this discussion ignores the effects of productivity growth on
demand for labor, and the unemployment rate will fall below 5%. But, as seems
likely, eventually workers will realize that inflation has accelerated and adjust their
wage demands to match. As wages rise again and catch up with prices, the demand
for labor will slacken and the unemployment rate will tend back to 5%.
As Figure 2 shows, when the terms of the trade-off shifted in the 1970s, the line
moved in a clockwise pattern. In the natural rate model, the clockwise cycling of
unemployment and inflation is due to the combination of expectations adjustments
and policy changes. Unemployment falls and inflation rises when policymakers, by
pursuing stimulative monetary or fiscal policies, attempt to exploit the “trade-off.”
At first the rise in inflation may be unexpected, but as inflation expectations adjust
and wage demands rise to maintain their purchasing power, the unemployment rate
tends to go back up. Contractionary policies designed to combat higher inflation
cause unemployment to rise further but also cause price increases to moderate.
Finally, as contractionary policy comes to an end and unemployment begins to fall,
inflation continues to fall as expectations adjust downward.
The implication of a shifting trade-off is that in the long run there is no trade-off
between inflation and unemployment. Although unemployment can temporarily be
pushed below the natural rate through expansionary policy, policymakers cannot opt
for an unemployment rate below the natural rate of unemployment and stay there.
Is Stagflation a Trap?
Stagflation is a relative phenomenon. It has no cardinal definition, it is simply
understood to be a period of high unemployment and inflation rates. As a relative
notion it would seem to be represented by the upper right hand area of Figure 2.
Where exactly in that figure stagflation starts and stops, however, is subjective.
References to stagflation in the popular press seem to suggest that it is viewed
as a kind of trap. That sentiment may be rooted in the 1960s view that there was a
trade-off between inflation and unemployment and that policy could not hope to
reduce one without raising the other. If the natural rate model is correct, concerns
that stagflation is a trap are mistaken.
Stagflation is generally understood to be a state of high unemployment and
inflation rates. It can be more precisely described in the context of the natural rate
model. In the view of the model, unemployment and inflation rates may be relatively
high at the same time, and they may even rise simultaneously for a time, particularly
if inflation and the natural rate of unemployment are rising at the same time. What
is unlikely to happen in this model is for the unemployment rate to be high and for
the inflation rate to continue accelerating. If the unemployment rate is above the
natural rate, then cooling labor and product markets would be likely to reduce upward
pressure on wages and prices. Once a slowing inflation rate came to be appreciated
by workers and was taken into account in their wage demands, demand for labor
would pick up and the unemployment rate would tend to fall.
Escaping a high inflation environment cannot be accomplished without a cost,
however. If individuals come to expect high inflation while the economy is at the
natural rate of unemployment, then the only way to reduce inflation would be to use
contractionary policy and temporarily push the unemployment rate above the natural
rate. Most economists believe that the reason the “double dip” recessions of the early
1980s were the deepest since the Great Depression was because the Fed decided to
use contractionary policy to reduce the inflation rate. Because the inflation rate was
so high, a long and deep recession was necessary to reduce inflationary expectations.
What is the Natural Rate of Unemployment?
Although the model may be useful on its own, it would be of more value if the
natural rate of unemployment could be known with some confidence. It probably
cannot be estimated with any precision and it may also be the case that it varies over
time because it is determined by labor market conditions and policies that change
over time.9 Most economists believe that the reason the United States was stuck in
a stagflation in the 1970s was because the natural rate had risen. From this
perspective, since policymakers were unable to recognize the rise until after the fact,
they directed policy to an unemployment rate that was unsustainably low. Recent
experience can also illustrate the effects of a changing natural rate.
Beginning in early 1994 and continuing into 1995, the Federal Reserve, in order
to prevent an acceleration in the rate of inflation, engineered a three percentage point
rise in short-term interest rates. This tightening of monetary policy began at a time
when the actual civilian unemployment rate was above 6%.
More recent economic experience suggests that the natural rate is below 6%.
In September 1994, the civilian unemployment rate fell below 6%, and with the
exception of a brief interruption from late 2002 through the middle of 2003 it has
remained below 6%. Between 1992 and 2005, consumer price inflation remained
below 3.5%. That the unemployment rate has been so low for so long with no
significant rise in the inflation rate has convinced many that the natural rate has fallen
since the 1980s, and that unemployment rates below 6% are compatible with a long-
run stable rate of inflation. It is worth noting, however, that since mid-2004 the
unemployment rate has been below 5.5%, and since late 2005 has been below 5%
while the inflation rate has picked up. That might be reason to believe the natural
rate is currently at or above 5%.
If the natural rate is now somewhere between 5% and 6%, it would be unlikely
for inflation to continue to accelerate if the unemployment rate were to rise above
6%. Inflation tends to exhibit considerable inertia and thus may be slow to respond
to an economy that is slowing down. For that reason there may be a period of time
where both the unemployment and inflation rates are relatively high. It is unlikely,
however, that both would rise over a prolonged period.
Supply Shocks: The Effects of Oil Prices
The preceding discussion suggested that stagflation was partially the result of
errors of policy. Not necessarily deliberate ones, but perhaps the result of uncertainty
9 Robert Gordon, “The Time-Varying Nairu and its Implications for Economic Policy,”
Journal of Economic Perspectives, vol. 11, no. 1, Winter 1997, pp. 11-32.
regarding how low the unemployment rate could go without eventually resulting in
accelerating rates of inflation. External events beyond the direct influence of policy
may also play a role, however. Stagflation in the 1970s coincided with two large “oil
Due to the central role energy plays in the functioning of our economy and its
unusual price volatility, changes in energy prices tend to have a greater short-term
impact on the economy than changes in the prices of most other goods. Energy
“shocks” can have macroeconomic consequences, in terms of higher inflation, higher
unemployment, and lower output. Historically, energy price shocks have proven
particularly troublesome for the U.S. economy. Sharp spikes in the price of oil have
preceded nine of the 10 post-war recessions. But since the current economic
expansion began in 2001, energy prices have spiked on several occasions.
Economic theory suggests that economies suffer from recessions due to the
presence of “sticky prices.” If markets adjusted instantly, then recessions could be
avoided: whenever economic conditions changed, price and wage changes would
automatically bring the economy back to full employment. In actuality, however,
there are menu costs,10 information costs, uncertainty, and contracts in our economy
that make prices sticky. As a result, adjustment takes time, and unemployment and
economic contraction can result in the interim.
When oil prices rise suddenly, it directly raises the energy portion of inflation
measures such as the consumer price index (energy prices make up about 9% of the
consumer price index.) As a result, the overall inflation rate is temporarily pushed
up since other prices do not instantly adjust and fall. If other energy prices rise at the
same time, as has often been the case, then the effect on overall inflation will be
Because energy is an important input in the production process, the price shock
raises the cost of production for many industries. Transportation accounts for a
majority of oil consumption in the United States, but hydrocarbons are also used for
heating and industrial uses, such as the production of plastics. Because other prices
do not instantly fall, the overall cost of production rises and producers respond by
cutting back production, which causes the contraction in output and employment, all
else equal. There may also be adjustment costs to shifting toward less energy
intensive methods of production, and these could temporarily have a negative effect
on output. Typically, the effect on output occurs over a few quarters.11
The effects described thus far can be thought of as occurring on the supply side
of the economy. Oil shocks may also affect aggregate demand. When energy prices
10 Products with high “menu costs” are those which are costly to re-price, and therefore have
sticky prices. Restaurant menus, periodicals, and catalog items are examples of products
with high menu costs.
11 If rising energy prices affect the economy through this transmission mechanism, then
falling energy prices should have the opposite effect on the economy: they should
temporarily lower inflation and raise output, all else equal. Many of the studies to follow
find that this is not true, however.
rise, they involve an income transfer from consumers to producers. Since producers
are also consumers, aggregate demand is likely to fall only temporarily as producers
adjust their consumption to their now higher incomes. This adjustment is likely to
be less or to take longer when the income recipients are foreigners than when they
Since the United States is a net importer of oil, the net effect on U.S. aggregate
demand depends on how foreign oil producers use their increase in wealth. The
adjustment to the wealth transfer from consumer to producer is transmitted through
the international balance of payments. How the increase in oil prices affects the
current account deficit (a measure that primarily consists of the trade deficit)
depends, in turn, on how foreign oil producers decide to use this purchasing power.
If they use it to purchase U.S. goods, then U.S. exports would increase and there
would be little effect on the current account deficit. If they use it to purchase U.S.
assets — whether corporate stocks, Treasury bonds, or by simply leaving the revenue
in a U.S. bank account — then it would represent an inflow of foreign capital to the
United States, which would increase the current account deficit. The purchase of
U.S. assets would stimulate total demand in the United States through lower interest
rates, possibly with a lag. Or the foreign oil producers may use their increased wealth
to purchase other countries’ goods or assets, in which case the adjustment process in
the United States could take longer.
A second effect on demand can be expected to occur because the rise in energy
prices will probably push up the overall price level because other prices do not fall
immediately in the face of a decline in demand. The increase in the price level will
reduce the real value of the available amount of money in the hands of buyers, and
this reduction in the value of money will also reduce spending. A third effect on
demand can occur if the rise in energy prices increases uncertainty and causes buyers
to defer purchases. This effect is also likely to be of a short run nature. The
magnitude of all three effects will depend on how much energy prices rise and how
long they remain high.
Both the inflation and output effects of energy shocks are temporary: that is,
once prices adjust, the economy returns to full employment and its sustainable
growth path.12 This observation yields an important insight: it is not the level of
energy prices that affects economic growth and inflation, but rather the change in
energy prices. Thus, if policymakers are concerned about the effect of energy prices
on output and inflation, they should focus more on rising energy prices than “high”
energy prices, even if the high prices are permanent. The only permanent
macroeconomic effect of higher energy prices is their negative effect on the terms of
trade. The “terms of trade” is a measure of standard of living that refers to the labor
and capital embodied in U.S. exports that can be exchanged for the labor and capital
12 This point is not always explicitly made in the time series analyses reviewed below, which
tend to end their estimates at the last time lag that yields statistically significant results or
arbitrarily cut off the estimates after a few lags to meet a statistical criterion concerning the
limit on the number of variables allowed.
embodied in foreign imports.13 It means that the United States has to give up more
of the goods it produces than previously to obtain a barrel of oil. Permanently higher
energy prices lead to a one-time permanent decline in the terms of trade and the
standard of living of U.S. consumers, all else equal.
Policy Implications. Historically, formulating an effective policy response
to oil shocks has been difficult. Expansionary fiscal or monetary policy increases
aggregate demand and inflationary pressures. In typical downturns, monetary and
fiscal policy can safely become expansionary without triggering a significant increase
in inflation because the fall in demand reduces inflationary pressures. In oil shocks,
policymakers must be simultaneously concerned with the fall in economic activity
and the rise in prices.
By tackling one problem, they risk exacerbating the other. For example, if
policymakers use expansionary fiscal or monetary policy to offset the fall in output,
prices may rise further and inflationary expectations could become embedded. A key
concern for policymakers is whether the rise in prices remains isolated in energy
prices or whether they spread to other goods (often referred to as “core inflation”).
This was the problem in the 1970s, when inflation, which was already rising before
the oil shocks, continued to accelerate following the oil shock of 1973 until it reached
double digits in 1974. Once the public came to expect higher inflation, the
subsequent expansionary policy measures had less and less of a positive effect on
aggregate demand, making any trade-off between inflation and unemployment less
and less favorable. Following the second oil shock of 1979, a Federal Reserve that
was determined to stamp out double-digit inflation chose instead to tackle the
inflationary pressures caused by the oil shock by raising interest rates. This decision
exacerbated the effect on output, contributing to the most severe economic
contraction since the Great Depression.
Although the rise in inflation in the 1970s is often attributed to the oil shocks,
some economists have disputed that assertion as well. If prices were perfectly
flexible, then a rise in oil prices could not raise the overall price level unless it was
“accommodated” by expansionary monetary policy. (Otherwise, other prices would
fall as much as oil prices had risen to keep inflation constant.) Since prices are not
perfectly flexible, it may be that higher oil prices temporarily cause overall inflation
to rise even without monetary accommodation. But unless oil prices are continuously
rising, a shock cannot cause inflation to rise on an on-going basis. For inflation to
keep rising, at some point, excessive monetary expansion is needed.
Another reason why policy responses have been unable to prevent oil shocks
from leading to recessions historically is because policy changes are hampered by
lags in policy recognition, implementation, and effectiveness. Because oil shocks are
typically unpredictable events, policy cannot be modified far enough ahead of time
to prevent a downturn.
13 See CRS Report RL32591, U.S. Terms of Trade: Significance, Trends, and Policy, by
Craig K. Elwell.
Is Stagflation Caused by Oil Price Shocks or Monetary Policy?
Despite the remarkable historical coincidence between oil shocks and recessions, a
strain of research has suggested that there might nonetheless be some third force
responsible for the recessions. In particular, the research has tried to separate the
effects of the oil shocks on the economy from the effects of simultaneous changes in
monetary policy. As the last section suggests, policymakers do have the option of
ignoring the inflationary effects of the shock and concentrating on its economic
effects. In that sense, the downturn can be seen as “caused” by policy, not the shock
itself. Some of the research has concluded that had it not been for the changes in
monetary policy, the oil shocks would have had little effect on economic growth.
Ben Bernanke, now Chairman of the Federal Reserve, and his co-authors were
interested in finding out what effects monetary policy changes had when they were
unanticipated.14 They chose to study oil shocks because these are one of the only
macroeconomic phenomena that most economists would agree are both unanticipated
and not the result of domestic policy. First, they estimated the effect of a 10%
increase in the price of oil when monetary policy responds as it has historically. They
estimated that over 24 months, GDP would fall by 3.1% and prices would rise by
0.09% relative to a baseline. To separate the effects of the oil shock from the effects
of the change in monetary policy, they then estimated a counter-factual example
where monetary policy does not respond to the oil price increase, which they
represented with a constant federal funds rate. In this case, GDP was estimated to
rise by 1.3% and prices by 0.13%. They concluded that oil price shocks have very
little negative effect on the economy; rather it is the monetary response to oil shocks15
that leads to the historical coincidence between oil shocks and recessions.
The work of Bernanke, et al. raises an interesting conceptual question: while the
effects of oil shocks and monetary policy can be statistically separated, can they be
separated in reality? Bernanke, et al. attribute the tightening of monetary policy
following oil shocks as the Fed’s response to the increase in inflationary pressures
that oil shocks are commonly believed to cause. Commenting on the Bernanke
paper, Sims points out that the assumption that monetary policy could remain
unchanged in response to an increase in inflationary pressures is not a reasonable one.
It is unlikely that private individuals would have no reaction to an unsustainable
policy, making the statistical separation of oil price effects from monetary effects
problematic.16 This would suggest that one can reasonably question whether there
is a practical distinction between attributing a recession to an oil shock or attributing
it to the monetary response to an oil shock.
14 Ben Bernanke, Mark Gertler, and Mark Watson, “Systematic Monetary Policy and the
Effects of Oil Price Shocks,” Brookings Papers on Economic Activity 1, 1997, p. 91. Their
regressions cover the period 1965-1995. None of their results is statistically significant.
15 Using similar methods, Ferderer found the opposite results: the effects of oil shocks were
larger than the effects of monetary policy. See J. Peter Ferderer, “Oil Price Volatility and
the Macroeconomy,” Journal of Macroeconomics, vol. 18, no. 1, winter 1996, p. 1.
16 Christopher Sims, “Comments,” Brookings Papers on Economic Activity 1, 1997, p. 146.
To address this criticism, Bernanke et al. also run simulations in which the federal funds rate
is held constant but expectations are assumed to adjust more quickly. Under this scenario,
output still rises and inflation rises slightly more quickly.
Hamilton and Herrera pursue this line of reasoning in a critique of the Bernanke
paper.17 Although Bernanke’s regressions can be mechanically interpreted to imply
that monetary policy could prevent a recession, Hamilton and Herrera point out that
these regressions would imply that the federal funds rate would have to have been an
improbable 9 percentage points lower in 1973 to prevent a recession. It is unlikely
that private individuals’ expectations would have remained unchanged in light of
such a significant policy change. Hamilton and Herrera also argue that Bernanke et
al. underestimate the effects of oil shocks because they use too short a lag length.
Bernanke et al. assume that changes in oil prices affect the economy for the next
seven months, whereas Hamilton and Herrera suggest a lag length of at least 12
months would be more appropriate since many works find the largest economic
effects of oil price changes come after three and four quarters. In particular, by using
a longer lag than Bernanke, they find that countering oil shocks with expansionary
monetary policy has much larger effects on inflation since monetary policy affects
inflation with a significant lag.
Barsky and Killian present a compelling analysis shown in Figure 3 that oil
shocks did not cause the recessions since the 1970s — the difference in timing
between the official onset of the recession preceded the rise in oil prices.18 The 1980
recession follows closely on the heels of the price increase, but the 1981-1982
recession was preceded by only a small increase in oil prices.19 The 2001 recession
began after oil prices had risen and already started to fall again, although economic
research suggests the rise in prices may affect the economy with a lag. But in the
1973 and 1990-1991 recessions, the recession began (as dated by the National Bureau
of Economic Research) before the oil price increased. These two experiences are
noteworthy because both recessions are closely associated in people’s minds with
geopolitical events linked to oil, the oil embargo and the Gulf War, respectively.
(This is not to suggest that those recessions were not made worse by the oil shocks.)
Furthermore, a well-known predictor of recessions, the yield curve inversion,
preceded the oil shock in 1973, 1978, and 1989, suggesting that the seeds for the
subsequent recessions may have been sown elsewhere.20
17 James Hamilton and Ana Maria Herrera, “Oil Shocks and Aggregate Macroeconomic
Behavior: The Role of Monetary Policy,” Journal of Money, Credit, and Banking, April
18 Robert Barsky and Lutz Killian, “Oil and the Macroeconomy Since the 1970s,” Journal
of Economic Perspectives, vol. 18, no. 4, Fall 2004, p. 115.
19 The 1981 to 1982 recession was widely viewed as the consequence of a more restrictive
monetary policy designed to reduce inflation and inflationary expectations.
20 See CRS Report RS22371, The Pattern of Interest Rates in 2006-2008: Does It Signal an
Impending Recession? by Marc Labonte and Gail Makinen.
Figure 3. Real Price of U.S. Crude Oil Imports and Recessions,
Source: Robert Barsky and Lutz Killian, “Oil and the Macroeconomy Since the 1970s,” Journal of
Economic Perspectives, vol. 18, no. 4, Fall 2004.
Stagflation is a reminder that economic analysis and economic policy have room
for improvement. Even without the complication of oil price shocks, it may arise
because policy is based on both imperfect information and an imperfect
understanding of the economy. (Economists note that the beginning of the upward
trend in inflation preceded the first oil shock.) The full effects of a change in
monetary or fiscal policy are felt some time after the fact, and that lag is uncertain
and may vary from one occasion to another. The effects of oil price increases or any
other external shock to the economy also take time to be fully realized.
Although policy may not be able to prevent episodes of stagflation from
occurring, there may be enough understanding of the underlying causes to avoid
making conditions substantially worse. Although increases in inflation may initially
be driven by forces that are out of policymakers’ hands, such as oil shocks, in the
long run high inflation cannot persist without monetary accommodation by the
Federal Reserve. Most economists believe that stagflation would not have lasted as
long as it did in the 1970s if the Fed had raised rates sooner, and believe that a
fundamental shift in Fed policymaking toward an emphasis on price stability explains
why stagflation has not occurred since. The 1970s experience with stagflation is seen
as the worst of both worlds — expansionary policy that delivered high inflation but
failed to deliver low unemployment — and the lesson that many economists have
taken from that experience is a skepticism that “activist” or “fine-tuning”
policymaking can deliver economic stability.
While stagflation is understood to be high rates of both inflation and
unemployment it is not clear how high those rates have to be to merit the designation.
The 1970s and early 1980s are the prime historical example of stagflation. The
unemployment rate reached 9.0% in May 1975 and a high of 10.8% in November
1982. The rate of consumer price inflation reached 12.2% for the twelve month
period ending in November 1974, and 14.6% for the twelve month period ending in
May 1980.21 Whether or not rates less than those constitute stagflation remains a
subjective matter. At the moment, both inflation and unemployment rates are well
below what they were in the 1970s episode.
Recent unemployment and inflation rates are not nearly as high as they were in
the 1970s. Some economists, however, fear that the recent expansion in monetary
and fiscal policy, at a time when unemployment is low but rising and energy prices
are rising, could lead to a new bout of stagflation in the near future. It remains to be
seen whether the recent loosening of policy marks a shift away from an emphasis on
21 At the time, the term “misery index” was used in the popular press to describe to sum of
the two measures. That measure is not addressed here because it has no analytical value.