Stagflation

I grew up with stagflation. In the 70s and 80s it was the word everyone reached for, here and abroad. Inflation and unemployment were both pushing towards double digits at times. The misery index piling up month after month. And it stuck around. The United States got out because Paul Volcker (Chairman of the Federal Reserve 1979-1987) broke the back of US inflation at the cost of a brutal global recession in the early 1980s. Australia took longer, with the recession we had to have in the early 1990s.

That experience was truly devastating. Real incomes fell, careers were lost, a generation of workers spent their peak earning years watching their wages erode in real terms while policy swung between accommodation and shock therapy.

The man on the street hates inflation far more than unemployment, for the simple reason that inflation hits everyone. Unemployment, brutal as it is for the people who experience it, leaves most of the workforce with a job and a pay packet. Inflation reaches into every household simultaneously. That is why the 70s felt like the economy was broken, rather than just bruised, and why central banks treat inflation as the primary enemy.

What is Stagflation

A working definition of stagflation goes something like: A sustained period of high inflation alongside materially weak or contracting real activity and rising unemployment, driven by unanchored inflation expectations. In the academic literature, the word typically refers to the 1970s in the United States. In Australia, inflation peaked in the 1970s, and unemployment peaked in the 1980s. Australia's closest analogue to stagflation spanned the mid-1970s to the mid-1980s, when both inflation and unemployment were historically high. While inflation reaccelerated in the late 1980s, the mechanism looked more like a credit-driven boom than the expectations trap of the earlier episode.

Current Australian conditions do not resemble the decade or so beginning in 1975. Using the word stagflation to describe moderately elevated inflation alongside slightly elevated unemployment is an abuse of the term. And hedges like "stagflation-adjacent" are worse than useless. They let a writer imply the scary thing without having to defend the claim. If you mean inflation is a bit above target and growth is a bit soft, say that. If you mean stagflation, show me the numbers.

So when people now say stagflation is back, my first instinct is to ask whether today's numbers deserve the word. In Australia today headline CPI is 3.7%, trimmed mean 3.3%. Unemployment sits at 4.3%. GDP grew 0.8% in the December quarter and 2.6% through 2025, the fastest annual pace in nearly three years. On no sensible reading does that get within shouting distance of what we lived through some forty years ago. If 5% on both CPI and unemployment for a quarter or two qualified, then stagflation would be a word we used routinely. We do not, because the word has always meant something more serious than that. Transitory coexistence of a lift in inflation and soft growth is common. Every supply shock produces some mild version of it.

Stagflation Is Anomalous

The deeper point is that stagflation is not supposed to happen at all. In a normal slowdown, demand weakens, firms discount to shift stock, wage growth eases, and inflation comes down with output. Unemployment rises while inflation falls. That's the trade-off the Phillips curve describes, and economists argue about how steep it is, not whether it exists. Rising unemployment alongside rising inflation should not be a stable combination. The economy should not generate stagflation by itself. It is persistent coexistence that is both the anomaly and the hallmark of stagflation.

What generates it is expectations. If households and firms stop believing inflation will return to target, they build higher numbers into wage claims, supplier contracts, and price lists. The original shock passes through, but the expectations it triggered do not. Real wages get defended, margins get defended, and the second-round effects turn a one-off into a grind. Growth slows because real incomes are hit and policy has to tighten hard, but inflation refuses to fall because everyone is already pricing next year's inflation into this year's decisions. That is the 1970s in one paragraph.

How The Seventies Actually Happened

The one-paragraph version is true but too compressed. The machinery matters, because the same machinery is still sitting in our economy waiting for the right conditions.

Start with a real shock. OPEC quadrupled crude prices in 1973-74 and doubled them again in 1979. That was a genuine terms-of-trade hit that cut Western real incomes by several percent of GDP. Every open economy was going to have a bad recession. That part was not a policy failure.

The policy failure was what happened next. Central banks accommodated. They raised rates, but not by enough. Real central bank rates in the US, UK, and Australia were negative through most of the 70s because unemployment was the dominant political concern and the intellectual consensus had not yet caught up with what was happening. At the same time governments typically ran expansionary fiscal policy. In Australia, the Whitlam government ran expansionary fiscal policy in the face of rising inflation. The subsequent Fraser government promised restraint but delivered too little of it to make a difference.

So this was the sequence. Oil shock raises headline inflation. The wage setting mechanism converts it to base wages. Accommodative monetary policy validates the higher wages rather than squeezing them back out.

Firms then reprice to protect margins. Households see inflation everywhere, stop believing it will come down, and start bargaining on the assumption that next year's inflation will match this year's. The original shock is long gone but the inflation stays, because the expectations it triggered have become the thing generating the inflation.

That is what "expectations coming loose" actually means. Not a mood shift. A set of institutional arrangements that converted a one-off supply shock into a self-sustaining loop, with a central bank that would not break the loop because the cost of breaking it was politically unacceptable.

The reason to walk through this is that the machinery is still there. We are facing an oil price shock from the Iran War. Enterprise bargaining is not 1975-style full indexation, but it is responsive to headline inflation. Minimum wage decisions look at CPI. Fiscal policy through 2022 and 2023 ran hotter than orthodox advice would have recommended. The ingredients that turned 1973 into 1983 have not been removed from the economy. What prevents a repeat is a central bank with the credibility and the institutional insulation to say no when saying no is unpopular. That is the whole of the mechanism. Strip it out and the machinery starts running again.

What The Data Actually Shows

Here is my estimate of Australian inflation expectations from a straightforward Bayesian signal extraction across surveys, bonds, wages, and realised inflation. No prior pinning it to target. Just textbook Kalman filtering on what the measurable proxies are telling us. Expectations are not observable, so any number here is an estimate rather than a measurement. That said, the filter is bog standard and the inputs are the ones any practitioner would use.

The current reading is 2.72%. That is above the 2.5% midpoint of the target band but still just inside the top of the band. It is elevated, but it is not unanchored. Nothing like 1986 or 1989, when expectations ran at 8%. Not even like the 2022-23 spike, when realised inflation pulled expectations up towards 3.5%.

The three-measure comparison sharpens the picture.

Long-run 10-year expectations, taken from the bond market, sit at 2.28%. Bond markets believe the RBA will get inflation back. Short-run 1-year expectations sit at 3.02%, above the band. The gap between them is the tell. People think current inflation is elevated but they trust the central bank to bring it back down over time.

That is what partial anchoring looks like. Long-run credibility is holding. Short-run expectations have drifted above target. Trimmed mean inflation has been running above the band for a sustained period now. The anchor has not slipped, but it is under tension, and the RBA is spending credibility to hold it there.

Look Through Or Lean In

With the war in Iran, it is quite possible that the next inflation print and the one after that will be higher. Petrol and diesel costs were materially higher in March.

My first instinct with supply shocks is to look through them. Hiking rates in response to the Middle East conflict just adds a demand shock on top of a supply shock and costs you unemployment for no inflation gain. The textbook answer is to let the shock pass through, accept the temporary bump in headline inflation, and keep policy focused on the underlying trend.

The critics who say the RBA cannot fix a supply shock are right. Monetary policy cannot grow more oil or unblock the Strait of Hormuz. But it can stop a supply shock becoming expectations creep, and that is the job that matters in this situation. The first-round effect is out of the Bank's hands. The second round, where the price rise becomes a wage claim becomes another price rise becomes an expectation that this is the new normal, is primarily in the Bank's hands. Institutions, bargaining power, and fiscal settings all matter for wage formation, but the Bank has the heaviest lever. You can only look through a supply shock while expectations stay anchored. The moment long-run expectations start drifting up, looking through becomes the mistake that lets the shock become entrenched. 

So the principle has a condition attached, and the condition is observable. The charts above tell you which mode you are in. If long-run bond-market expectations hold inside the band and trimmed mean is heading back toward target, look through. If long-run expectations make a sustained move outside the band, stop looking through and lean in hard. The trigger is not "feels a bit elevated." It is a clear break in the market-based measure.

The Taylor Rule In One Idea

John Taylor's contribution, stripped to its essence, is this. When inflation is above target, the central bank should raise the policy rate by more than the excess. Not one-for-one. More. If inflation runs a point above target, the policy rate needs to rise by more than a point, so that the real interest rate actually tightens. Do less than that and you have loosened policy at exactly the moment you meant to tighten it, because inflation has eaten the nominal rise.

The rule is not a formula anyone follows mechanically. It is a discipline. It tells you whether a central bank is serious. A serious central bank responds strongly enough to re-anchor expectations. An unserious one lets the real rate drift down while announcing hikes, and wonders later why inflation got away.

The RBA Is Doing Roughly The Right Thing

The RBA's job right now is genuinely hard. The war in Iran has given them a classic oil shock, and they are walking a precipice. On one side is a recession caused by over-tightening into a supply shock that should fade on its own. On the other side is an inflation crisis caused by under-tightening into a shock that becomes entrenched through expectations. Both errors are costly. The information to distinguish them in real time is limited. The expectations data is the main signal they have, and the expectations data is currently ambiguous. Short-run expectations say tighten. Long-run expectations say hold. The Bank has chosen to lean slightly toward tightening, and that call is defensible even if it is not obvious.

The asymmetry helps them. The cost of under-tightening is not a future Volcker recession, it is a decade of stagflation first and then a Volcker recession to end it. The cost of over-tightening in Australia often presents first as a per capita recession rather than an outright aggregate contraction. Our immigration rate keeps the headline numbers growing through most cycles, and households feel poorer while the national accounts say the economy is still expanding. That happened through 2023 and 2024. It is politically painful, it hurts the leveraged household sector, and it is recoverable in a way that the Volcker alternative is not. Given that asymmetry, erring slightly toward the hawkish side is the right bias, even when the immediate case for action is thinner than the Bank's communications suggest.

The RBA has lifted the cash rate twice this year to 4.10% and Deputy Governor Hauser has publicly named the stagflation risk, calling it a 'central banker's nightmare' in his New York speech earlier this month. That matters more than it sounds. A central bank willing to say the word out loud is a central bank that does not intend to let it happen.

The Domestic Verdict

My read on Australia is this. Inflation sits a touch above target. Short-run expectations have drifted. Long-run expectations are holding. Unemployment will rise as the tightening bites, because unemployment lags inflation on the way down. The Iran war adds real uncertainty to the oil price. None of this is crisis territory, but none of it is comfortable either.

That is the boring answer to the question at the top of this post. No, we are not about to get stagflation. The RBA has decades of credibility and is using it. But the credibility is not a free resource. It gets spent every quarter inflation runs above band, and the Bank cannot afford to be complacent.

The Real Risk Is In Washington

The bigger worry sits offshore. A disciplined RBA cannot fully insulate Australia from the world's largest economy losing its own discipline. The United States exports inflation through the dollar, through commodity prices, and through global financial conditions. What Martin Place does in Sydney matters. What the Federal Reserve does in Washington matters more.

And what is happening in Washington is not reassuring. The Trump administration has been running a sustained pressure campaign to lower interest rates. The president has publicly attacked Chair Jerome Powell for months and repeatedly threatened to fire him. The Department of Justice launched a criminal investigation into Powell that a federal judge described as an unjustified act of intimidation. The administration tried to remove Governor Lisa Cook, and the Supreme Court is now considering how far presidential authority over Fed appointees extends. Kevin Warsh, the president's nominee to succeed Powell, sat for his confirmation hearing this week and was pressed on whether he could maintain independence from the White House. He said he would. We will see.

Arthur Burns (Chairman of the Federal Reserve 1970-1978) is the usual comparison here. Burns caved to Nixon in 1971 and 1972 and arguably seeded the Great Inflation. What may be unfolding now is structurally worse than Burns. Burns was one man buckling under pressure from one president. What the pattern of actions above suggests is a broader test of whether the institution can resist political control. A compromised chair, a constrained board, a Supreme Court ruling that could settle whether the president can remove governors at will. Burns was a failure of personnel. In prospect is the potential failure of architecture, and architecture does not rebuild itself once it is gone.

The Volcker story from the opening of this post is the case for why architecture matters. Volcker did the right thing and was hated for twenty years. A central banker who has to face voters cannot do what Volcker did, because the payoff comes two decades after the election that would end their career. The only way a Volcker is possible is if the institution insulates the person. Strip the insulation, and you guarantee Burns every time.

The rest of the world is likely to be more disciplined. The ECB will do its job. The Bank of England will do its job. The central banks in Canada and Japan will do their jobs. The RBA will do its job. But discipline at the periphery only helps so much when the anchor fails.

This goes back to exorbitant privilege. Giscard d'Estaing coined the phrase as French Finance Minister in 1965, in frustration that the US could print dollars to fund the Vietnam War while France could not. De Gaulle was simultaneously demanding the US convert French dollar holdings into gold, draining American reserves. The phrase was an accusation, not a compliment, and the resentment has been baked into the system ever since.

It captures the structural fact underneath all of this. The US gets to borrow in its own currency, run persistent deficits, and have the rest of the world absorb the consequences because everyone else needs dollars for trade, reserves, and commodity invoicing. That privilege has underwritten American economic exceptionalism for sixty years. It is supposed to come with an obligation. The reserve currency issuer runs disciplined monetary policy because everyone else is depending on the anchor to hold. The US gets the privilege, the world gets the anchor, and both sides benefit. Other countries have tolerated the uneven deal precisely because the US has held up its end.

A Fed that cuts rates on political demand rather than economic merit tries to keep the privilege without honouring the obligation. For a while that works, because the dollar's network effects are sticky. Nobody switches to a different reserve currency overnight. But the credibility underwriting the privilege erodes immediately. Long-run expectations drift. Term premia rise. Other central banks diversify reserves at the margin. The privilege does not end in a single dramatic event. It ends through a thousand small adjustments as the rest of the world recalibrates what the anchor is worth.

Australia is a price taker inside this system. We accept the inflation rate the anchor economy produces, plus or minus some exchange rate adjustment and whatever the RBA can squeeze out through domestic tightening. A disciplined Fed is a subsidy to every open economy with a floating exchange rate. A politicised Fed is a tax on the same economies. We have been collecting the subsidy for forty years since Volcker and have come to treat it as a feature of the landscape rather than a thing that could be taken away.

If the Fed loses its independence and US inflation re-accelerates, the dollar falls, commodity prices rise in USD terms, and the imported component of our inflation gets harder to contain. We would end up tightening further than we otherwise would, for longer than we otherwise would, to offset a problem we did not create. There is a limit to how hard the RBA can tighten against an imported shock before it breaks the domestic economy trying. And there is nothing else we can do. We have no vote in US elections, no seat on the Supreme Court, no influence over Senate confirmations. The RBA can only choose which form of pain we absorb.

The historical precedent is not encouraging. The Australian inflation Burns helped export ran through the entire 70s and into the early 80s. Even after Volcker took over in 1979, it took until 1983 for our inflation to come back inside single digits, and until 1991 for Australia to properly reset its macro framework. Eight years of bad Fed policy bought us more than a decade of inflation problems. The mechanism was being a price taker then. The mechanism is being a price taker now. Only the names have changed.

And the answer is?

So my answer to whether Australia is about to get stagflation is a conditional one.

On current domestic fundamentals, no. Our numbers do not qualify, the RBA is moving, expectations are holding, and the RBA has decades of credibility to draw on. While we might see a period of slowing growth and above target inflation, the RBA should insulate us from stagflation itself. In short, the domestic outlook is uncomfortable but manageable.

However, if the global reserve currency and the world's largest economy go Arthur Burns, we along with the rest of the world will probably get stagflation anyway. Not because the RBA failed, but because no small open economy can fully insulate itself from a compromised U.S. Federal Reserve System. The 70s were a global phenomenon for a reason. The anchor failed in Washington and everyone else got dragged into the slough of despond.

Follow-up

A follow-up piece, Stagflation: the Lead in Australia's Saddle, looks at why Australia took so much longer than peer economies to get inflation back under control after the 1973 oil shock.