There was a time when many economists thought it would be impossible to have a situation where a country faced high inflation while struggling with stagnant economic growth and high unemployment.
But stagflation became a bitter reality when the oil embargoes of the 1970s stunted economic growth and sent prices north.
For policymakers, dealing with stagflation is particularly difficult because the tools they use to counter one of the two problems – high inflation or low growth – usually end up making the other worse.
Stimulating demand and consumption, for example, would only make inflation worse. But raising interest rates to reduce inflation could hurt growth because it dampens borrowing and investment.
Although the causes of stagflation are much debated, a common theory is that it happens when an economy faces a supply shock: an unexpected event causes a shortage or an increase in the price of a important raw material, such as oil.
In such a scenario, prices soar and make production more expensive and less profitable, thus slowing economic growth.
“Stagflation is really a problem of sustained reduction in living standards,” said Walter Theseira, an economist at Singapore University of Social Sciences. , so that the standard of living falls much faster than during a “normal” recession.
The last bout of stagflation is widely believed to have been triggered by an oil embargo in October 1973 that caused severe gas shortages around the world.
Members of the Organization of the Petroleum Exporting Countries (OPEC) temporarily halted shipments of oil from the Middle East to the United States and other countries in retaliation for their support for Israel during the 1973 Arab-Israeli war .
Crude oil prices rose from US$3 a barrel in 1970 to US$12 in 1974. Soaring fuel prices stifled economic output while driving up the cost of goods and services, leading to high wage demands and galloping inflation.
The United States entered a recession, registering five consecutive quarters of negative growth between 1973 and 1974, and unemployment peaked at 9% in May 1975. Inflation, meanwhile, reached double-digit levels in the country in 1974.
In Singapore, rising oil prices pushed headline inflation to nearly 20% in 1973 and to around 30% year-on-year in the first half of 1974. The growth rate of the Republic’s gross domestic product (GDP) fell from 10.6% in 1973 to 6.1% in 1974.
Faced with the prospect of stagflation, the Monetary Authority of Singapore (MAS) implemented several monetary policy measures aimed at curbing inflation, including raising bank reserve requirements from 5% to 9%, l imposition of credit limits on banks and finance companies as well as raising interest rates by 2 percentage points.
In the second half of 1974, inflation began to moderate and the MAS gradually eased its monetary policy to support growth. Singapore’s economy avoided a recession and managed to grow by 4% in 1975, while headline inflation for the year was 2.6%.