What is ‘stagflation’ and why is it a worry?

‘Stagflation’ is a term that makes regular rounds on the news and can be a point of real concern for the markets.

It refers to an economic condition when inflation is rising, but gross domestic product (GDP) and employment levels are flat or shrinking. This means that while goods and services are getting increasingly more expensive, the country is not seeing an influx of cash to keep pace. The effect trickles down to individuals, who face rising household costs on top of a tight job market.

Inflation rising without GDP growing may seem like a counterintuitive phenomenon, and many economists would agree. In fact, many thought it was impossible for inflation to rise and GDP to shrink at the same time, until it happened in the 1970s. But since then, it has been a major point of caution for governments and markets.

Recently, worries about stagflation have swirled around the news because US tariffs imposed by President Donald Trump have worried economists about rising inflation rates. Even before the tariffs were announced, the Federal Reserve had backed off forecasts for interest rate cuts in 2025 because of concerns that the taxes would force inflation upwards as goods became more expensive.

What’s the UK’s inflation situation?

This makes sense for the US. But what does it mean for the UK?

Regardless of international influences, the Bank of England itself has said inflation is on a “bumpy path”. It very briefly reached its 2% inflation goal last summer, but current forecasts expect inflation to hit 3.7% this summer before going down again.

As with any future forecasts, these must be taken with a grain of salt. Just last year, the Bank of England predicted interest rate cuts to begin early on, but inflation took longer than expected to drop, delaying those interest rate cuts.

Other factors, like the UK introducing retaliatory tariffs on the US, could also cause an inflation spike as products from the US sold in the UK could become more expensive. But how inflation will be influenced in the UK is really yet to be seen.

It’s likely GDP will also be impacted by US tariffs. On ‘Liberation Day’, Trump announced an umbrella 10% tariff on the UK, with automobile exports taxed at 25%. This is widely expected to harm the UK’s growth forecasts. Recent Office for Budget Responsibility (OBR) forecasts showed GDP growing by 1% this year but then averaging 1.8% growth for the rest of the decade, but these figures could be heavily influenced by tariffs.

What are the signs of stagflation, and solutions?

Economists and markets are on alert for signs of stagflation, but it can be hard to pinpoint. Inflation rates bounce around with factors like energy prices causing temporary effects, making long-term patterns harder to predict. GDP has similarly been a point of worry for the UK, but for the past three years has slowly edged upwards. According to the Office for National Statistics (ONS), GDP grew by 1.1% in 2024, an acceleration from the 0.4% growth in 2023.

The real problem with stagflation comes with trying to fix it, because inflation and GDP are often used as levers against each other. But when those levers aren’t working, central banks and governments might have to turn to other measures.

One way to do this is an increase in productivity, which would boost GDP. But practically speaking, this is a tall order in a limited amount of time. Another option is taking more extreme measures with interest rates. This was the approach taken in the 1970s, when the phrase stagflation was first coined.

What can we learn from when stagflation happened before?

When stagflation first occurred in the 1970s, there was no single cause. Governments in the UK and in the US were following Keynesian financial models, which meant that government intervention was used to keep economic growth on track.

But the decade saw a spike in oil prices that coincided with dispute among industrial workers, leading to strikes and unemployment. The issues caused the rate of return on capital to dip below the interest rate set by the Bank of England by 1975. While businesses were previously supported by government stimulus (similar to that seen during the COVID-19 pandemic), this began to run dry, and businesses instead laid off workers and increased prices to make up for profits.

This combination of tactics by businesses provided a perfect environment for stagflation, as inflation increased as people were charged more, and fewer workers meant less growth.

To end this cycle in the UK, the government raised interest rates to a peak of 17% in 1979, and widely cut back government spending. While this did eventually lead to a calming of inflation and GDP began to pick back up as labour contracts were established, it did cause pain for the public. Stagflation pushed unemployment from 3.5% in 1973 to 11.9% to 1984.

How worried should I be?

The effects of stagflation can be concerning, and it’s a difficult position to recover from. But it’s important to recognise that the direction the economy is heading is never set in stone. There’s a large variety of known factors that could cause changes in inflation levels in the next few years, and there’s another bundle of unknowns. On the side of growth, there will always be market adaption even if trade with the US tightens the purse strings.

The most helpful way to protect yourself from the effects of stagflation is to ensure that your investments are in a comfortable position for your future plans and are well diversified to weather different market conditions.