What is stagflation and why is it so dangerous?

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.

Economist Milton Friedman was one of the first to predict the stagflation of the 1970s. Friedman understood that the Federal Reserve wields incredible power to increase or decrease inflation in the U.S. In Friedman's worldview, inflation happens when the Fed allows too much money to circulate in the economy. His formula for inflation is simple: "Too much money chasing too few goods."

The dual mission of the Fed is to keep prices stable and maximize employment [source: Hobson]. The strategy for achieving this mission is called monetary policy. Modern monetary policy is heavily influenced by Friedman's theories.

When the economy is growing, the Fed raises interest rates to limit the amount of money in circulation. When the economy slows, the Fed lowers interest rates to encourage borrowing and increase the amount of money in circulation. The goal is to strike a precarious balance where the economy grows at a healthy rate without allowing inflation to get out of control.

In the 1960s, in an effort to maximize employment at all costs, the Fed lowered interest rates and flooded the economy with money. This led to increased demand for goods and services and rising prices. When it was clear in the 1970s that inflation was spiraling out of control, the Fed and the federal government took the erroneous approach of pumping more money into the system even as real economic output sagged. This fit Friedman's formula for inflation: too much money chasing too few goods.

It wasn't until 1979, with the appointment of Fed chairman Paul Volcker, that the Fed put Friedman's monetary policy theory into practice [source: Orphanides]. Volcker raised interest rates, choking off the flow of money into the economy. It meant high unemployment and a significant recession in the early 1980s, but inflation returned to normal levels and the economy eventually stabilized.

The threat of stagflation is greatly increased during a recession, when GDP is slumping and unemployment is on the rise. According to standard monetary policy, the Fed lowers interest rates during a recession to encourage borrowing and spending. The key to preventing stagflation is to avoid allowing too much money to enter the economy too quickly.

To successfully avoid stagflation during a recession, Fed economists need to accurately predict both the short- and long-term performance of the economy. They have the difficult job of identifying the turning point -- when the country emerges from recession -- and slowly pulling money out of circulation. This requires impeccable timing. If the Fed raises interest rates too soon, it could kick the legs out from under the restarting economy. If it waits too long, the economy can become overheated with extra cash, causing prices to rise and inflation to soar [source: Gogoll].

Keep reading for lots more information about the economy, the Fed and currency.