What Is Stagflation?

Stagflation and tariffs. You’ve probably heard both terms if you’ve been paying attention to economic news lately… Here’s what they are and why you should worry.

What Is Stagflation?

The word “stagflation” is a combination of two words – “stagnation” and “inflation” – which is pretty much what it is. This (thankfully infrequent) condition is when the economy is stagnant while prices keep going up.

Why Is Stagflation Unusual?

Two opposing forces usually affect our economy: unemployment and inflation. 

When the economy grows fast, companies looking to expand hire more employees, reducing unemployment. This is a good thing for employees because it leads to wage increases as employers seek to retain their current employees and hire new ones.

Wage increases, in turn, mean that workers have more free cash, so they buy more goods and services. This increased demand, if not balanced by a fast enough increase in supply, leads to price increases, or inflation.

This is how lower unemployment usually leads to higher inflation.

The opposite is also true.

When the economy stagnates, companies seeking to improve their bottom line try to reduce costs. One way they do this is by letting some employees go and pushing those still employed to be more productive. Fear of losing their jobs tends to enforce this management demand.

This leads to higher unemployment.

As unemployment increases, the unemployed (obviously) have less money, and even those still employed hunker down and try to hold on to their jobs. This means wages typically don’t increase much. As a result of all this, workers have less cash and tend to put off discretionary spending in case they lose their jobs.

This reduces demand, which dampens price increases, leading to lower inflation.

This relationship between unemployment and inflation is captured by the so-called “Phillips Curve,” and the economy tends to move up and down the curve between heating up, which reduces unemployment and increases inflation, and cooling down, which increases unemployment and reduces inflation.

The Fed’s mission is to try and keep things as close to the middle as possible, with inflation around 2% and unemployment around 3-5%. As the Labovitz School of Business and Economics at the University of Minnesota states, “Most economists believe that the natural rate of unemployment (when the economy is at full employment) falls somewhere between 4% and 5%. Rates too far below that range can have a variety of negative impacts on the economy, including recruitment and retention challenges, lost productivity, and more.”

The above describes how the economy usually behaves.

However, sometimes it behaves very differently.

Sometimes, prices get pushed up despite the economy not growing or even contracting – stagflation.

What Causes Stagflation?

While “normal” inflation is driven by how much money workers have, stagflation is when prices increase due to other factors.

Factors such as supply shocks, increased tariffs, and economic uncertainty.

If raw materials (e.g., chemicals, oil, lumber, steel, etc.) are less readily available, their prices increase even if demand stays constant. Further, this lack of raw materials slows down economic growth. A perfect example of this was seen in the early 1970s, when the Organization of Petroleum Exporting Countries (OPEC) declared an oil embargo on the US.

Economic stagnation + increased prices = stagflation.

Increased tariffs exert similar pressure on the economy by increasing the cost of imported goods. Since, per the Department of Commerce, nearly half of the goods sold in the US depend on imports, higher tariffs lead to widespread inflation. These higher costs lead to reduced demand and slower economic growth, which, in turn, causes employers to tighten their belts, leading to higher unemployment.

Higher prices + slower economic growth = stagflation.

Companies may increase prices due to external factors. When this coincides with economic uncertainty, workers worry about losing their jobs. Concerned that the money they’ve squirrelled away won’t cover their needs, they put off discretionary spending. Since consumer spending accounts for over two-thirds of our Gross Domestic Product (GDP), reduced spending leads to the economy contracting.

Higher prices + contracting economy = stagflation.

Why Is Stagflation Especially Worrisome?

As mentioned above, the Fed tries to optimize unemployment and inflation.

When the economy heats up and inflation increases, they push short-term interest rates up (fiscal tightening). Between the impact of inflation (as described above) and increased borrowing costs, companies lay off employees. Increasing unemployment reduces demand, which cools down inflation.

On the flip side, if the economy enters recession (i.e., an extended period of contraction), the Fed reduces short-term interest rates, and the government may increase its spending to boost the economy. Lower borrowing costs and greater government spending prompt companies to hire more people, which pushes down unemployment.

But what’s the Fed to do when the economy enters stagflation?

Inflation is high, so they want to increase interest rates. However, at the same time, the economy is stagnant, so they want to reduce interest rates and increase government spending to pump it up. In short, the Fed’s inflation-fighting tools worsen economic stagnation, while what helps pump up the economy worsens inflation.

It’s a “Catch 22.”

Since no fiscal tools address economic stagnation and high inflation together, it’s hard to get the economy out of stagflation.

How Does Stagflation Affect You?

First created by economist Arthur Okun, the so-called “misery index” adds up the seasonally adjusted unemployment rate and inflation, which together measure workers’ suffering.

As described above, high unemployment usually leads to lower inflation, and vice versa. Thus, in typical times, the misery index stays relatively stable.

During stagflation, however, inflation is high while the economy stagnates, and unemployment is higher than it would be if inflation were caused by the economy heating up. Thus, workers have fewer job openings and wages stagnate (or worse, drop), all while prices increase.

The perfect storm of economic misery.

How Likely Are We to Enter Stagflation Now?

As quipped by Nobel Prize laureate Nils Bohr, “It’s hard to make accurate predictions, especially about the future.”

Lacking a functional crystal ball, nobody knows if stagflation will hit us until it does (or doesn’t).

However, current conditions make the risk higher than normal.

• The Trump administration is pursuing an aggressive tariff policy, which is widely expected to push prices up on a broad range of products, since imports will be more expensive, and companies that previously had to compete with lower import prices will be able to increase their prices once imports are less competitive.
• Higher inflation makes it harder for the Fed to reduce interest rates, stifling economic growth.
• China, responding to the Trump tariffs, announced that it is stopping exports of rare earth minerals, critical to modern technology (e.g., smartphones; computer components such as memory chips, solid-state memory drives, and LED or LCD monitors; televisions; powerful permanent magnets needed for electric motors and wind turbines; lasers used in telecommunications and medical devices; high-energy-density batteries needed for electric vehicles, EVs; catalytic converters needed to reduce emissions from non-EV cars; MRI contrast agents; aircraft engines, radar systems, and missile guidance systems; oil refining; etc.).
• Repeated announcements of new tariffs, tariff increases, tariff delays, etc., lead to extreme economic uncertainty, which, in turn, makes companies less likely to hire or otherwise invest.
• The massive national debt periodically needs to be refinanced as bonds mature, and in a high-interest environment, this pushes up the government’s debt servicing cost, making it more difficult to stimulate the economy through higher government spending.
• The Trump administration’s push to slash entire government departments and agencies and dramatically reducing the budget of others, drags the economy down both directly, through lower government spending, and indirectly, through the layoffs of civil servants and government contractor employees, as well as employees of companies who depend on federal workers’ ability to keep spending.
• Restrictions on immigration and a push for mass deportation tighten the labor market, especially in terms of unskilled labor, such as migrant farm workers. This will likely lead to higher produce prices.
• All the above lead to increasing expectations that prices will go up, which is often a factor in reinforcing higher inflation. When companies expect higher inflation, they tend to raise their prices to maintain or grow their inflation-adjusted profits. Employees then demand higher wages to keep up with the expected (and actual) increases in their cost of living. Higher wages mean higher production costs, which, again, pushes consumer prices higher.

Joshua Mangoubi, founder of Considerate Capital Wealth Management, elaborates, “Stagflation poses a real risk for the first time in many decades, as the economy shows stagnation alongside rising prices. The current situation with high inflation and new tariffs raising costs means we must acknowledge this possibility, even though it doesn’t (yet) represent my primary expectation. 

“Trade barriers act like indirect taxes for consumers and businesses, which reduce economic growth while simultaneously driving prices up, much like the situation in the 1970s. 

“Although stagflation remains a possibility rather than a certainty, current economic conditions have increased its chances, which demands our vigilance.” 

How Can You Proactively Prepare Yourself Now in Case Stagflation Hits?

I asked financial advisors in the Wealthtender community for their best ideas on what you can do proactively now to prepare your finances to weather a possible period of stagflation.

Brian Rhoads, Checkpoint Financial Planning, kicks things off with a possible investment suggestion and a cautionary note, “In a stagflation scenario, Treasury Inflation Protected Securities (TIPS) would, as the name suggests, protect your investment from losing purchasing power due to inflation. In addition to tracking inflation, your investment could provide a positive ‘real’ yield – a return above inflation if held to maturity. 

“One caveat: TIPS are bonds, and selling any bond before maturity could result in a realized gain OR loss in price.”

Mangoubi elaborates, “To protect your portfolio against stagflation risk, think about restructuring towards resilience. 

“Investors may incorporate inflation protection measures through investments in commodities, TIPS, and other tangible assets. Stock pickers should focus on businesses that maintain low fixed costs combined with sustainable competitive advantages. Such businesses sustain profit margins amid inflation because they adjust faster to market changes, transfer cost increases to customers, and rarely require substantial reinvestment to remain competitive. Seek out companies that control their pricing, together with those that provide vital products and possess strong customer loyalty. 

“While no one can predict the future with certainty, taking practical, forward-looking steps today can help safeguard your financial well-being if stagflation takes hold.”

Ryan Goldenhar, co-founder of Wealth With Options, adds, “In a stagflation environment, focus on the ‘flation’ part of the word, which means prices might rise faster than your income. Review your budget to identify what might be eliminated, trimmed, or substituted using a less expensive alternative. For example, perhaps your family’s summer vacation could be driving a rented RV, instead of a plane trip and staying in expensive hotels.”

Reggie Fairchild, financial advisor, Flip Flops and Pearls Financial recommends, “Double down on paying off high-interest debt, especially Buy Now, Pay Later (BNPL) balances and credit cards. 

“If we see stagflation, the Fed could be forced to raise interest rates, making short-term, variable-rate debt even more expensive, rising ‘faster than a California wildfire.’ Don’t let yourself or your adult children get caught off guard. Encourage them to prioritize paying off this type of debt aggressively. It’s one of the financial moves most likely to save money.” 

According to CBS News, “60% of Coachella attendees used a payment plan to buy their festival passes. ‘Buy now, pay later’ (BNPL) options have become much more popular for large purchases like rent, but even for smaller purchases like food delivery. And they are only expected to get more popular in the future.”

As Fairchild points out, “This may indicate that younger buyers are stretching to buy tickets.”

What You Need To Know About Stagflation

Stagflation is a pernicious economic condition that increases the “misery index,” due to high unemployment rates happening while prices go up. While the Fed has tools to address a stagnant economy or high inflation, it has few, if any, tools that can address both at the same time.

While it’s impossible to predict with any certainty that we’re about to experience a period of stagflation, multiple factors that are typical harbingers of stagflation have cropped up, implying that stagflation risk is much higher than usual, though some economists say that risk is still low.

On the personal front, if you expect stagflation to hit, you want to take steps now that will position you to weather such a scenario better than most people. These may include:

• Making yourself indispensable at work (e.g., picking up high-value skills, making your supervisor’s life easier, etc.) to reduce your risk of being laid off.
• Investing in resilient companies and other defensive assets that weather recessions well.
• Aggressively paying down debt, especially debt with adjustable interest (e.g., Home Equity Lines of Credit – HELOCs, Adjustable Rate Mortgages – ARMs, credit card debt, etc.).
• Looking for ways to trim your expenses proactively now, before economic realities force you to take especially unpalatable steps.
• Considering if it’s time to start a recession-proof business.

Of course, these are all good steps to consider, even if stagflation doesn’t materialize.

Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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