TL;DR: Understanding stagflation is important for anyone planning for retirement or managing investments during uncertain economic conditions. This article explains how stagflation occurs, what causes it, how it compares to inflation and recession, and what steps you can take to protect your finances.
- Stagflation occurs when inflation remains high while economic growth slows and unemployment rises.
- Learn the differences between stagflation vs inflation and stagflation vs recession, including how each affects consumers and investors.
- Explore a historical stagflation example from the 1970s and the similarities between that period and recent economic conditions.
- Discover the role of the Federal Reserve and how higher interest rates are used to combat inflation.
- Find practical strategies to prepare for a potential period of stagflation, including strengthening emergency savings, reducing debt, and understanding stagflation and the stock market.
There has been a lot of talk about “stagflation.” What does that mean?
Economic conditions can change rapidly. Inflation spikes, slowing growth, market volatility, and changing employment trends often lead investors to ask: What is stagflation, and how does it affect financial planning?
In 2022, while general confidence did drop to the point that the New York Times reported, “Americans generally feel as bad about the economy as they did during the Great Recession of 2008,” wages kept rising and the unemployment rate stayed low. However, some experts are concerned that we may be nearing a period of stagflation.
Stagflation Defined
Stagflation is a mashup of “stagnation” and “inflation.” It describes an economy in which inflation continues to rise despite low or no economic growth and high unemployment.
Since we already have high inflation and negative growth, if a large number of people were to lose their jobs, we could enter a stagflationary period.
When comparing stagflation vs inflation, inflation refers to rising prices alone. Stagflation occurs when rising prices are combined with weak economic growth and elevated unemployment.
Lessons from History
We can look back to stagflation nearly 50 years ago as an anecdotal guide to factors that may contribute to it today.
In the early ‘70s, President Nixon took the United States off the gold standard, which allowed the value of the dollar to become more volatile. The subsequent decline in the dollar’s value started an inflationary rise that continued throughout the decade.
That inflation was then exacerbated in 1973 when the Organization of the Petroleum Exporting Countries (OPEC) declared an oil embargo against the United States.
This is one of the most commonly cited stagflation examples in modern economic history.
This caused gas prices to skyrocket. Businesses reacted by both increasing prices and decreasing production, driving inflation to stratospheric levels not seen since 1947. Prices continued to rise despite a sharp increase in job layoffs. This was the situation that gave rise to the term “stagflation.”
Similarities Between the 1970s and Today
There are a number of parallels between the economy of the 1970s and today. Inflation has increased dramatically, though not as drastically as in the ‘70s.
The economy has experienced two quarters of negative growth, which meets one definition of recession.
The debate around stagflation vs recession is important. A recession typically involves declining economic activity and rising unemployment, while stagflation combines economic stagnation with persistent inflation.
Both of those situations were partially caused by soaring gas prices. The 1970s increases were due to OPEC’s embargo, and the price spikes in 2022 were the result of Russia’s war against Ukraine.
Today’s economic news sounds eerily similar to the 70s, but there are key differences to note. One change is the Fed’s reaction to inflation.
This year the Fed raised target interest rates four times between March and July and has signaled willingness to do so again throughout the rest of 2022 and into 2023. In the 1970s, however, the Fed was slow to react to soaring inflation. When it finally took action, a “stop-go” policy was implemented in which target interest rates would be raised significantly for a very short time, then dropped back down.
This policy proved a dismal failure at curtailing inflation, which would continue its meteoric ascent until 1979, when a new Fed chair, Paul Volcker, significantly raised interest rates and kept them high. This caused a recession but did finally bring inflation down to normal levels.
Combining the differing Fed reactions to inflation with today’s low unemployment rate shows that the current situation, while uncomfortable, is not identical to conditions in the Age of Disco. This makes it difficult to assume whether or not stagflation will occur. But what would result if it were to happen?
Preparing for Stagflation
If stagflation does happen in the near future, most experts don’t think it will be as bad as the1970s episode.
Many people ask what causes stagflation. Historically, contributing factors have included supply shocks, rising energy prices, restrictive production environments, and monetary policy challenges.
Beef up your emergency fund. Try to keep at least six months of living expenses in an easily-accessible account. This can help you weather a job loss or an unforeseen emergency like a medical bill or home repair without having to dip into your retirement accounts.
Pay off adjustable-rate debt. Periods of higher interest rates can increase borrowing costs and place additional pressure on household budgets. While being careful not to neglect your retirement account contribution, it’s a good idea to concentrate on paying down variable-rate debt when interest rates are in flux.
Investors should also understand the relationship between stagflation and the stock market. During a period of stagflation, corporate profits can face pressure from rising costs and slowing demand, creating additional market volatility.
Consider Partnering with a Professional
At Asset Preservation Wealth & Tax, we routinely work with clients to help them take advantage of the good times while remaining prepared to weather the bad ones. I’ve had a lot of nervous clients ask about stagflation this year, wanting to know if it will happen and what they should do about it.
While no one can predict when it might occur, you can take steps to prepare your finances should stagflation happen. The good news is that even if stagflation doesn’t materialize, getting ready for it means you’ve made your finances healthier. That’s always a good idea!
Predicting the future isn’t possible, but you can still do your best to prepare for all eventualities. Working with a financial advisor can help you plan for an unpredictable future and work toward a successful retirement.
Frequently Asked Questions About Stagflation
What causes stagflation?
Stagflation can result from several factors, including supply chain disruptions, rising energy costs, restrictive production conditions, and monetary policy challenges. These events can slow growth while prices continue to rise.
What is the difference between stagflation vs recession?
A recession is generally characterized by declining economic activity and rising unemployment. Stagflation includes economic stagnation, inflation, and unemployment occurring at the same time.
What is a common stagflation example?
The most well-known stagflation example occurred during the 1970s in the United States when high inflation, slow growth, and rising unemployment followed energy supply disruptions and oil price shocks.
How does stagflation affect investments?
Stagflation and the stock market can have a complicated relationship. Rising costs may reduce company profits, while slower economic growth can limit earnings opportunities, creating market volatility.
Can the Federal Reserve prevent stagflation?
The Federal Reserve can use monetary policy tools such as raising or lowering interest rates to influence inflation and economic activity. However, because stagflation is rare and has multiple causes, preventing it can be challenging.
Stewart Willis is the founder and president of Asset Preservation Wealth & Tax, a financial planning firm in Phoenix, Arizona. Investment advisory services offered through Foundations Investment Advisors, LLC, an SEC registered investment adviser.
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