What Is Stagflation and Why Should We Worry About It?

The Spotlight

5 minutes read

Apr 12, 2022

The U.S. and Europe are now facing the risk of stagflation, a term which refers to economic stagnation and high inflation.

It looks like stagflation could be here soon. Here’s what you need to know to understand the economic phenomenon that stifled growth through the 1970s.

2022 was supposed to be the year when the world moved on from the economic woes of the pandemic and entered a new phase of recovery and prosperity.

But, apparently, the situation we’re in now is quite the opposite.

In our previous Spotlight, we said there’s a chance the U.S. and Europe are now facing an economic phenomenon known as “stagflation”.

Sounds a bit scary, right?

But don’t worry - we are here to explain what stagflation really is and what could it mean for your investment portfolio. Because, as we like to say, forewarned is forearmed.

So let’s start.

What is stagflation, exactly?

Quite obviously, it’s a combination of the words “stagnation” and “inflation”.

slow economic growth causing stagflation represented by a picture of a man riding a snail.

It refers to an economic condition that’s caused by slow growth and high unemployment (economic stagnation) mixed with rising prices (inflation).

When was the concept of stagflation coined?

The term appeared as early as in 1965, when British Conservative Party politician Iain Macleod in a speech to parliament said:

“We now have the worst of both worlds — not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation and history in modern terms is indeed being made."

Stagflation was initially thought to be impossible by many economists, mostly because the unemployment rate and the rate of inflation usually move in opposite directions.

However, now we know stagflation is a real thing, and can have quite a devastating effect on the economy, as the 1970s' "Great Inflation" period showed.

What is the difference between inflation and stagflation?

Although stagflation and inflation are closely related, they should not be confused.

Inflation is defined as a long-term increase in the average price level of all goods and services in an economy.

And, in fact, inflation can sometimes be good for the economy because it can help boost consumer demand and consumption, driving economic growth.

Stagflation, on the other hand, is avoided at all costs.

Quick tip

There can be inflation without stagflation, but stagflation is always accompanied by inflation.

What causes stagflation?

Economists have three main theories about what causes stagflation:

  • A sudden increase in oil prices.
  • Poor economic policies.
  • Supply shocks.

Let’s look at them in more detail.

Theory #1: A sudden increase in oil prices

Stagflation is thought to be caused by a sudden increase in oil prices that reduces an economy's productivity.

oil barrels and red arrow pointing at skyrocketing oil prices that are one of the possible causes of stagflation

The idea is that producing products and getting them to stores becomes more expensive as transportation costs rise, leading to increase in prices and people losing their jobs.

Did it happen in the past?

In fact, yes.

In October 1973, OPEC imposed an embargo on Western nations, causing the global oil price to soar, and thus raising the cost of goods and contributing to a surge in unemployment.

And it looks like we might be having a similar situation today:

Following Russia’s invasion of Ukraine, global oil prices soared above $100 a barrel, pushing fuel prices in the U.S. and Europe to record levels. This has already begun to weigh on consumer confidence and retail store visits.

Theory #2: Poor economic policies

Another theory says that poor fiscal and monetary decisions also cause stagflation.

The Fed’s policies are too little too late to combat rising inflation and are one of the root causes of stagflation

Another theory says that poor fiscal and monetary decisions also cause stagflation.

Allowing inflation to run amok and then slamming the brakes is one example of bad policy that some have suggested contributes to stagflation.

Others point to the tight controls on markets, goods, and labor, as well as the ability of central banks to print unlimited amounts of money.

Do we see it happening today?

Well, some economists say the Fed’s policies are “too little too late” to tame runaway inflation, and even risk pushing the U.S. into recession.

Oh, and don’t even get us started on massive money printing: the central bank has been creating dollars from thin air at an unprecedented rate to rescue the economy amid the Covid-19 pandemic.

Theory #3: Supply shocks

Finally, there’s a view that stagflation can also be caused by supply shocks which can reduce the capacity of the economy to produce goods and services at given prices.

A cartoon man trying to fix a broken supply chain which one of the many causes of stagflation

Supply shock definition

A supply shock occurs when an unexpected event changes the supply of a product resulting in an unforeseen price change.

By an unexpected event we mean a stranded oil tanker blocking other ships from accessing a trade route (hi, Evergreen), or longer-term issues, such as a war, or a global health crisis.

If we look at today’s situation, the “supply shock” theory fits in quite well. During the pandemic, there were supply shocks in:

  • Goods: for example, chip shortages which started even before the Covid pandemic.
  • Labor: Covid locked many people at home, sent entire cities into lockdown and has generally disrupted the workforce in many countries, thus creating labor shortages all over the globe.

What could stagflation mean for you?

Well, to begin with, if it happens, don't panic.

Experts say stagflation shouldn't significantly affect your way of life if you have been living within your means.

However, they also see a sound, long-term financial plan as the best way to protect your wealth from stagflation.

For example, if you have planned making large purchases, such as buying a home, you might want to delay them for a while, mostly because rising construction costs make new homes more expensive.

Otherwise, if you have a job and money to spend, you should continue making regular purchases, while also improving your saving and investing habits.

How to prepare your investment portfolio for stagflation?

The short answer is diversification.

To be more precise, if your portfolio has riskier investments (stocks, crypto, etc.), now could be a good time to balance it out with assets that work best during stagflation.

What are they? The table below will give you an idea:

A table that shows asset classes that work best in a stagflationary environment.
A table that shows asset classes that work best in a stagflationary environment.

As you can see, stagflation can have a negative effect on the stock market and might push the value of some of the riskier assets down.

At the same time, rising inflation has historically worked well for gold and silver, often pushing their price up.

So what should you do now to protect your wealth from possible stagflation? We think you already know the answer.


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