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Inflation vs. Recession vs. Stagflation: We Define the Risks of Each

Rising prices combined with a slow economy could hit Americans with a double whammy.
Nuthawut Somsuk/iStock/Getty Images

What's happening

Inflation is steep and economic growth is sluggish. Economists say that a recession, or even stagflation, is a high risk.

Why it matters

Stagflation (a rare combination of high inflation and high unemployment) ravaged the US economy in the 1970s and early 1980s.

What it means for you

Soaring prices mean that gas, food and necessities are more expensive, and a slow economy means it's harder for Americans to earn money, secure employment and save.

Are we headed toward an economic meltdown? As wages struggle to keep up with the skyrocketing prices for basic goods and layoffs are starting to roll in, the economy looks scary. Inflation has surged by 8.6%, the largest annual rise in four decades, and US households, particularly low-income Americans, are feeling severe financial strain.

The stock market is also taking a hit, with the S&P 500 down 20% this year. The Federal Reserve plans to continue raising the federal funds rate to try to slow the economy. Many financial experts are concerned that we could soon be facing a recession. The World Bank warned in its June report that the global economy could be facing a period of stifled growth, leading to broader financial destabilization. 

Fears of stagflation -- a period defined by rising prices alongside slow economic growth and high unemployment -- are also accelerating among Wall Street analysts and economists. The COVID-19 pandemic, supply chain disruptions and the global consequences from the war in Ukraine are creating a toxic mix that could steer the economy into an even bleaker state, with prices remaining high and an increase in layoffs. 

What exactly is the difference between inflation, recession and stagflation? Here's everything you need to know about rising prices and where the economy might be headed.

First, what is inflation?

Simply put, inflation is a sustained increase in consumer prices. It means a dollar bill doesn't get you as much as it did before, whether you're at the grocery store or a used car lot. Inflation is usually caused by either increased demand (such as COVID-wary consumers being finally ready to leave their homes and spend money) or supply side factors like increases in production costs and supply chain constraints. 

Inflation is a given over the long term, and it requires historical context to mean anything. For example, in 1985, the cost of a movie ticket was $3.55. Today, watching a film in the theater will easily cost you $13 for the ticket alone, never mind the popcorn, candy or soda. A $20 bill in 1985 would buy you almost four times what it buys today.

Typically, we see a 2% inflation rate from year to year. It's when the rate rises above this percentage in a short period of time that inflation becomes a concern.

What about stagflation? Is it the same as a recession?

The slowdown in the US economy during the first quarter of 2022 has raised concerns of a recession, but stagflation fears are steadily mounting. According to Bank of America's latest fund manager survey, 83% of investors expect a period of stagflation within the next 12 months. 

A recession refers to a period of prolonged economic decline and market contraction where the unemployment rate goes up and production goes down, generally slowing inflation. Stagflation, on the other hand, refers to a period where a recession is uniquely coupled with high inflation. 

A mash-up of "stagnation" and "inflation," the term stagflation was coined in 1965, when British politician Iain Macleod lamented the country's growing gap between productivity and earnings: "We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both together. We have a sort of 'stagflation' situation and history in modern terms is indeed being made."

Stagflation became more widely known during what was known as the Great Inflation in the US in the 1970s. As unemployment hit 9% in 1975, inflation kept ratcheting upward and reached more than 14% by 1980. Memories of this dismal economic period have factored into current fears about out-of-control inflation. 

Economic circumstances today have some parallels to the 1970s, but also major differences. During the energy crises then and today, a disruption in the supply chain helped fuel inflation, followed by a period of relatively low interest rates, in an attempt to expand the supply of money in the economy. Unlike the 1970s, though, both the dollar and the balance sheets of major financial institutions are strong. The US unemployment rate also still remains low, currently sitting at 3.6%, according to the Bureau of Labor Statistics.

When do we know we're in a period of inflation?

Inflation isn't a physical phenomenon we can observe. It's an idea that's backed by a consensus of experts who rely on market indexes and research. 

One of the most closely watched gauges of US inflation is the Consumer Price Index, which is produced by the federal Bureau of Labor Statistics and based on the diaries of urban shoppers. The CPI reports track data on 80,000 products, including food, education, energy, medical care and fuel.

The BLS also puts together a Producer Price Index, which tracks inflation more from the perspective of the producers of consumer goods. The PPI measures changes in seller prices reported by industries like manufacturing, agriculture, construction, natural gas and electricity.

And there's also the Personal Consumption Expenditures price index, prepared by the Bureau of Economic Analysis, which tends to be a broader measure, because it includes all goods and services consumed, whether they're bought by consumers, employers or federal programs on consumers' behalf. 

The current inflationary period generally started when the Labor Department announced that the CPI increased by 5% in May 2021, following an increase of 5% in April 2021 -- a rise that caused a stir among market watchers

Though a rise in the CPI in and of itself doesn't mean we're necessarily in a cycle of inflation, a persistent rise is a troubling sign. 

How did we get such high inflation in the first place? 

Today's inflation was originally categorized as "transitory" -- thought to be temporary while economies bounced back from COVID-19. US Treasury Secretary Janet Yellen and economists pointed to an unbalanced supply-and-demand scale as the cause for transitory inflation, provoked when supply-chain disruptions converged with high consumer demand. All of this had the effect of increasing prices.

But as months progressed, inflation started seeping into portions of the economy originally undisturbed by the pandemic, and production bottlenecks persisted. The US was then hammered by shocks to the economy, including subsequent COVID variants, lockdowns in China and Russia's invasion of Ukraine, all leading to a choked supply chain and soaring energy and food prices.

"I think I was wrong about the path that inflation would take," Yellen told CNN in late May. "There have been unanticipated and large shocks to the economy that have boosted energy and food prices and supply bottlenecks that have affected our economy badly that I didn't -- at the time -- didn't fully understand, but we recognize that now."

How can the Federal Reserve try to ease inflation?

The Fed, created in 1913, is the control center for the US banking system and handles the country's monetary policy. It's made up of 12 regional Federal Reserve banks and 24 branches and is run by a board of governors, all of whom are voting members of the Federal Open Market Committee, which is the Fed's monetary policymaking body.

While the BLS reports on inflation, the Fed moderates inflation and employment rates by managing the supply of money and setting interest rates. Part of its mission is to keep average inflation at a steady 2% rate. It's a balancing act, and the main lever it can pull is to adjust interest rates. In general, when interest rates are low, the economy and inflation grow. And when interest rates are high, the economy and inflation slow. 

The federal funds rate is the interest rate banks charge each other for borrowing and lending. When the Fed raises this rate, banks pass on this rate hike to consumers, driving up the overall cost of borrowing in the US. Consequently, this often drives consumers, investors and businesses to pause their investments, rebalancing the supply-and-demand scales disrupted by the pandemic.

Raising interest rates makes it more expensive for businesses and consumers to take out loans, meaning buying a car or a home will get more expensive. Moreover, securities and cryptocurrency markets could also be negatively affected by this: As interest rates increase, liquidity in both markets goes down, causing the markets to dip.

Consequently, this often drives consumers, investors and businesses to pause their investments, rebalancing the supply-and-demand scales disrupted by the pandemic.

With rates well over the 2% inflation goal, the Fed reacted by raising rates a quarter point in March, a half point in May and three-quarter points in June. The Fed has noted that we are likely to see more rate hikes this year -- as many as six total. In June, Fed Chairman Jerome Powell indicated that another 0.5 or 0.75 percentage point increase is likely at the Fed's next meeting in July. 

What about deflation, hyperinflation, shrinkflation?

There are a few other "flations" worth knowing about. Let's brush up.

Deflation

As the name infers, deflation is the opposite of inflation. Economic deflation is when the cost of living goes down. (We saw this, for example, during parts of 2020.) Widespread deflation can have a devastating impact on an economy. Throughout US history, deflation tends to accompany economic crises. Deflation can portend an oncoming recession as consumers tend to halt buying in hopes that prices will continue to fall, thus creating a drop in demand. Eventually, this leads to consumers spending even less, lower wages and higher unemployment rates. 

Hyperinflation

This economic cycle is similar to inflation in that it involves an increase in the cost of living. However, unlike inflation, hyperinflation takes place rapidly and is out of control. Many economists define hyperinflation as the increase in prices by 1,000% per year. Hyperinflation is uncommon in developed countries like the US. But remember Venezuela's economic collapse in 2018? That was due in part to the country's inflation rate hitting more than 1,000,000%.

Shrinkflation

Tangentially related to inflation, shrinkflation refers to the practice of companies decreasing the size of their products while keeping the same prices. The effect is identical to inflation -- your dollar has less spending power -- and becomes a double whammy when your dollar is already weaker. Granola bars, drink bottles and rolls of toilet paper have all been caught shrinking in recent months.

Michelle Meyers and Justin Jaffe contributed to this report.