What Is Stagflation and Can You Protect Yourself
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Stagflation, an economic term obsolete since the 1970s, has returned to the American lexicon.
Former Federal Reserve Chairman Ben Bernanke has warned of stagflation; more recently, the World Bank downgraded its forecast for the global economy, citing factors such as stagflation. The fallout from the Russia-Ukraine war, supply chain snags, and remnants of COVID-19 have eaten into economic activity at home and abroad and could affect consumers and employers. In the U.S., energy prices are rising, inflation remains high, and the country is also facing severe product shortages, raising fears of stagflation.
But what is stagflation, and what, if anything, you can do to protect yourself?
In this article
What is stagflation?
Coined by a British politician in 1965 in a speech in the House of Commons, stagflation is a toxic brew of stagnant economic growth, rising unemployment rate, and high inflation.
In a bid to kickstart the economic engine, governments typically lower interest rates. This encourages spending and makes saving a less attractive option. People take out loans, and they generally spend more. All of this activity helps increase economic output. Even as lower interest rates result in higher inflation, people tend to spend more to avoid paying higher prices in the future.
In normal economic conditions, higher unemployment results in lower spending, which makes sense because if you're not earning, you'll likely take a cautious approach to spending money. This phenomenon helps rein in demand and helps put a stop to price increases. This is also explained via a Phillips curve, a popular theory that posits that unemployment should be accompanied by higher inflation or vice versa.
But stagflation turns this theory on its head. The economy can act irrationally when muted economic growth is accompanied by higher inflation. This puts central banks in a conundrum. If they try to bring stagflation to heel through lowering interest rates, inflation could propel higher, making it unlikely for the consumers to spend. On the other hand, if interest rates are increased, borrowing money becomes expensive and economic growth falters even more. Stagflation does seem like a lose-lose scenario because regardless of the levers central banks pull. They risk either increasing the cost of living or affecting economic growth, making it likely for a recession to set in.
Related: What Is a Recession?
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Stagflation vs. inflation
To better understand stagflation, you have to know what inflation is. When prices of goods and services rise sustainably, it is described as inflation. Put another way: it's the decline of your purchasing power; your dollars don't go as far as they used to. In the U.S., inflation continues to accelerate rapidly, rising 8.6% in May, a four-decade high. The Fed targets an inflation rate of 2%, and it has consistently increased interest rates to course-correct the U.S. economy. The Fed's efforts have yet to bear fruit, however.
Inflation can psychologically affect people, potentially leading to more inflation. But it results in higher asset prices and powers economic growth. Investing in stocks, bonds, and real estate can hedge against inflation.
Related: What is inflation?
What causes stagflation?
While economists haven't reached a consensus on the causes of stagflation, two main theories have been advanced.
Supply shock
An unexpected event can affect the supply of a commodity or service, such as oil. In fact, this scenario is currently playing out. As Russia and Ukraine lock horns, oil prices have increased not just across the U.S., but in several other economies as well. The Organization of the Petroleum Exporting Countries (OPEC) decision to increase oil production is also expected to do little to alleviate the global oil balance. America's first, and thus far only, brush with stagflation was the result of higher oil prices.
Poor economic policies
Clashing a central bank's monetary policy and the government's fiscal policy can also usher in stagflationary times. For example, a government can increase taxes, leading to less income, as the central bank engages in quantitative easing. As the government's policy affects growth, the central bank's action would lead to inflation. A growing chorus of influential voices has accused the U.S. Federal Reserve of doing too little too late to cool an overheated economy.
How to protect yourself from stagflation
Have an emergency fund
Stagflation brings about a double-whammy of bad news. As unemployment rises, you may find yourself out of a job, and your purchasing power may weaken simultaneously amid high inflation. A rainy-day fund ensures you can remain current on bills and afford any necessities. Experts recommend opening a high-yield savings account and depositing money into it as soon as you receive your paycheck. Ideally, an emergency fund should have enough money that you can sustain yourself for at least six months.
Related: How to Start an Emergency Fund
Watch your spending
This is the first rule of personal financial 101, but it's especially true during economic distress. You should think twice before making large purchases or buying anything that's not an essential item; that new smartphone can wait. You may also pay down debt because the government may raise borrowing rates to steady the ship. Not only will your emergency savings last longer by being mindful of your spending, but it may even promote healthy financial habits once the economy is back on track.
Reallocate your portfolio
You must remain in the stock market, but you should factor in bleak economic conditions and revisit your portfolio. Stocks that pay dividends, mutual funds, and ETFs are all worthy investments. You should avoid growth stocks and stick to value and cyclical stocks. The markets may freefall at any time, but it's important that you keep a cool head and don't panic sell. In the long run, stocks always go up.
Related: Best Stocks to Buy
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What central banks can do
Stagflation is a double-edged sword for central banks. The economy may enter a recession if they raise interest rates to fight inflation. High interest rates promote saving and increase borrowing costs. So, if you were considering a mortgage or a car loan, you will likely delay that purchasing decision because you'll now be charged more money. This results in slow economic growth, and these prolonged periods may force the economy into further distress.
A recession is defined as two consecutive quarters of decline in the GDP, and the Fed's GDPNow tracker shows the economy is on the brink of a recession. After a 1.5% fall in the first quarter, the GDP tracker points to a second-quarter annualized gain of 0.9%. But Treasury Secretary Janet Yellen has said the U.S. is unlikely to face a recession.
Stagflation of the 1970s
A series of measures undertaken by President Richard Nixon, now called the Nixon Shock, set the groundwork for stagflation in the 1970s.
Nixon put in effect a freeze on wages and prices, and a 10% tariff on imports, among other things, in 1971. These actions were meant to rein in inflation. For its part, the Fed increased the federal funds rate to tamp down inflation, only to reverse it later as recession crept in. The Fed's stop-and-go measures only served to exacerbate the problem. An oil embargo by the OPEC on the U.S. in 1973 aggravated the situation and caused prices to skyrocket.
As a result of the oil crisis, oil prices rose significantly, and so did the cost of doing business. Demand and industrial output suffered, making goods scarce.
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The bottom line
Stagflation is an ancient relic that may or may not make a return (depending on who you ask) in the U.S. It is not to be confused with inflation, a term used to describe a sustained increase in the price of goods and services. Stagflation is characterized by macroeconomic factors like low economic output, high unemployment, and inflation. Supply shocks and poor economic policies can cause stagflation, as evidenced in the 1970s — America's only brush with a period of stagflation. You can navigate this bleak economic condition better by having an emergency fund in place, being mindful of your spending, and diversifying your portfolio. The only way for an economy to pull itself out of stagflation is to increase productivity without affecting inflation, which is easier said than done.
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Writer
Jasir Jawaid is Joy Wallet's Assistant Editor. He has more than 13 years of experience as a journalist covering Wall Street, equities, financial policy and regulation, and cryptocurrency and blockchain.
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