Stagflation doesn’t happen to the American economy too often, but when it does, its ripple effects can affect policymakers, economists, and investors. Here’s an overview of stagflation: what it is, what causes it, and how to think about your own finances if it hits.
What is stagflation?
Stagflation is the combination of high inflation, stagnant economic growth, and high unemployment. The meaning is right in the name—the word “stagflation” is a mash-up of “stagnant” (in reference to the economy) and “inflation” (the rate of rising prices). Typically in periods of high inflation, central banks will restrict the money supply in the economy by raising interest rates or mandating banks keep more cash on hand. That could slow growth and reduce prices. A period of stagflation is a particular challenge for economists because levers that tend to alleviate inflation could worsen an existing pressure, like rising unemployment.
How does stagflation work?
Usually, when economic growth slows and there is higher unemployment, people have less spending money, so demand for goods and services falls. That generally causes prices to fall, too. During a period of stagflation, however, prices continue to rise while the economy stays the same or even contracts. That could hurt consumers who may already be struggling financially.
What causes stagflation?
Although there’s no single factor that has caused periods of stagflation, historically, there are a few market conditions that have paved the way.
Large changes in supply and demand for critical commodities
A substantial shortage or rise in demand of an essential good could spur high inflation as well as an economic downturn. For example, the 1973 oil crisis saw the price of oil rise dramatically in the US after an embargo, setting off a period of stagflation. A commodity price spike high enough to trigger stagflation could come from the demand side instead of the supply side. In that case, the government, people, and corporations would be willing to pay high prices for a given resource. That could potentially cause that commodity price to continue rising without the economy growing, leading to stagflation.
Government policies
Monetary and tax policies and increased market or production regulations could cause stagflation, as could international conflict and a government’s response to it. The decrease in supply from international trade, the shift in government spending, and the increased demand for certain commodities used in war could all raise inflation without necessarily expanding the economy.
What are the consequences of stagflation?
Stagflation could impact your personal finances in the following ways:
Low purchasing power
Although stagflation may not cut your salary outright, high inflation may reduce your purchasing power. (In other words, $50 won’t buy as much as it used to.) Unless you’re receiving regular raises to counteract inflation, your take-home pay may be not be able to cover as much. If unemployment is high, employers aren’t likely to lift wages to compete for easy-to-find talent.
Recessions
High unemployment, possibly leading to fewer goods and services being produced, combined with high inflation, possibly leading to fewer goods and services being bought, could cause a recession—a prolonged period of negative economic growth. A recession could mean poor stock market performance too, because of the lack of growth as well as the fact that people may invest less money and sell investments they already owned.
Higher interest rates
The Federal Reserve could increase the Federal funds rate to try and rein in high inflation. This could increase the cost of borrowing, which would immediately affect credit card interest rates and could influence interest rates on mortgages, auto loans, and student loans. But keep in mind that the Federal Reserve has the dual responsibility of regulating inflation and unemployment. High unemployment with high inflation may make it a difficult decision for the Fed to raise rates and possibly worsen unemployment.
How is stagflation fixed?
Although there’s debate around the best ways to handle stagflation, the stagflation in the US in the 1970s and 1980s was addressed with large interest rate hikes from the Fed. Other options to help fix inflation include changing supply-side policies in hopes to incentivize growth and reduce costs to critical resources. Keep in mind, though, that each case of stagflation is caused by a unique set of domestic and international circumstances.
Stagflation vs. inflation
Inflation is part of stagflation, but high inflation doesn’t necessarily mean there’s stagflation. High inflation often happens when a central bank loosens its monetary policy, making borrowing money cheaper and increasing the cash supply in the economy. With lower borrowing costs, companies find it easier to invest and grow. Growth typically means more jobs and higher wages, which in turn boosts economic expansion. The flip side is that with more money in the economy and in consumers’ pockets, prices can also rise, causing higher inflation. Unlike some periods of inflation, stagflation is when there are rising prices but no economic growth.
Stagflation vs. recession
Although stagflation could cause a recession or happen during a recession, the economic conditions have different criteria. A recession is an extended period of economic decline, often defined by negative gross domestic product (GDP) growth. In the US, the National Bureau of Economic Research (NBER) decides if the economy is experiencing a recession by examining additional signs like real income, purchasing power, employment levels, industrial output, and retail sales. Recessions are more common than stagflation, and, in fact, are a normal part of an economy’s life cycle. Stagflation, on the other hand, requires high inflation on top of economic decline and high unemployment. Inflation doesn’t typically rise during a recession.
When has stagflation happened in the past?
In the US, stagflation occurred during the 1970s through the early 1980s. A leading factor for it was the Arab oil embargo that began in October 1973, soon followed by the Iranian Revolution in 1979. These 2 events created an oil shortage in the US, causing the cost of crude oil to quadruple, stay elevated, and then triple. In turn, manufacturing became more expensive, raising prices across the country and slowing economic growth.
What can you do to protect yourself from stagflation?
Investors, historically, have gravitated towards certain assets and investment strategies to help protect their money during times of stagflation. Here are 3 strategies to explore:
Revisit your emergency savings
Although your emergency fund isn’t an investment strategy itself, having a cash cushion in case your income sources change can help you stick to your investment plan and avoid taking on debt. Fidelity suggests that after building up a cash buffer of $1,000, you work toward setting aside enough to cover 3 to 6 months’ worth of essential expenses. If inflation is rising, it’s wise to recalculate the cost of your essential expenses each month and make sure your emergency savings is robust enough.
Invest in a diversified mix
Haven’t looked at your portfolio in a while? Check in and see what’s going on with your investments. Diversification doesn’t protect against loss, but it can help you manage risk. If your ideal investment mix is out of whack due to the price growth or fall of assets in your portfolio, it may be time to rebalance.
Research investments that have historically done well during high inflation
If you’re looking for further protection, you could look into investments that tend to do well during periods of inflation. For instance, Treasury Inflation-Protected Securities (TIPS) and I bonds both pay more interest when inflation rises. Stocks related to commodities, such as energy, industrial metals, precious metals, and agriculture products, have historically done well in inflationary environments. As always, ensure any new investments fit within your overall investing strategy. If you’re unsure, consider talking to a professional for help.
