What is stagflation and why is it so dangerous?

Stagflation in the 1970s

The word stagflation didn't even exist until the 1970s. From 1958 to 1973, the United States experienced what's known as the "Post-War Boom." Gross annual products in Western nations grew by an average of 5 percent annually, fueling a slow but steady rise in prices (inflation) over the same period [source: Cleveland].

So why did things go sour in the 1970s? It turns out that the Federal Reserve's monetary policy during the boom years of the late '50s and '60s was unsustainable. The economists at the Fed were diehard Keynesians who believed in something called the Phillips Curve. The Phillips Curve charts the relationship between unemployment and inflation. Historically, when unemployment is low, inflation increases, and when unemployment is high, inflation decreases.

In the 1960s, the Fed believed that the inverse relationship between unemployment and inflation was stable. The Fed decided to use its monetary policy to increase overall demand for goods and services and keep unemployment low. The only tradeoff, economists believed, would be a safely rising rate of inflation [source: Concise Encyclopedia of Economics].

Unfortunately, they got it wrong. The result of unnaturally low unemployment in the 1960s was something called a wage-price spiral. The government poured money into the economy to increase demand, making prices rose. Workers, noting the rise in prices (inflation), expected their wages to rise accordingly. For a while, employers were willing to raise wages, but then inflation began to rise faster than wages. Workers weren't willing to supply labor for lower wages, so unemployment increased even as inflation continued to rise [source: Hoover].

But the wage-price spiral alone wasn't enough to trigger killer stagflation. The real kicker was the OPEC oil embargo of 1973, which brought oil prices to record new levels. Prices skyrocketed, not only at the gas pump -- where long lines and shortages were common -- but across all U.S. industries.

In 1970, inflation was 5.5 percent. By 1974, it was 12.2 percent, and then it peaked at a crippling 13.3 percent in 1979 [source: Jubak]. The stock market ground to a halt. From 1970 to 1979, the S&P 500 returned an average of 5.9 percent annually. But when you subtract for inflation (average 7.4 percent annually), the market lost value every year. The annual return on bonds was 2.6 percentage points lower than inflation [source: Jubak].

President Jimmy Carter and the Fed tried numerous tactics to stabilize the economy, including wage and price guidelines and large government spending (and borrowing), both of which only seemed to exacerbate the problem.

In the next section, we'll take a look at how the Fed finally got stagflation under control and how it can be prevented in the future.