You have probably heard of inflation or the gradual rise in the prices of goods and services. But what exactly is stagflation, and what should investors be aware of it? Let’s start by understanding the difference between inflation and stagflation.
Inflation vs Stagflation
Inflation is a general increase in the price of goods and services across the economy. Historically it has been associated with unemployment, interest rate, and investment environment. Inflation causes the purchasing power of a currency to weaken. For example, if you spend $100 per week on groceries, and the inflation rate is 4%, you will need to spend $104 the following year.
It is a combination of the term stagnant and inflation. Stagflation is a term that refers to a stagnant economy due to both slow economic growth, high unemployment, and rising prices (inflation).
Generally, the rate of unemployment and inflation move in opposite directions. Many economists initially thought that stagflation was impossible. However, the “Great Inflation” in the 1970s demonstrated that stagflation is real and can be catastrophic to the economy.
Cause and effect of Inflation
Inflation is more than just the rise in prices. Inflation generally occurs when the demand for goods and services is higher than the supply. It also happens when the GDP grows slower than the money supply. The Covid-19 pandemic has recently become the cause of inflation due to a disrupted supply chain and increased consumer demand. Moreover, the increase in oil prices following Russia’s invasion of Ukraine in 2022 exacerbated the current high inflation.
Individuals who put their money on saving accounts and live on a fixed income, investors holding long-term bonds, variable-rate mortgage holders, and people with credit card balances are the most affected by inflation. Savers suffer from inflation because the increasing prices will decrease their purchasing power of money, and the actual value of savings falls. Inflation may prompt the government or central bank to raise interest rates. As a result, mortgage holders with variable mortgage rates may see a significant increase in their mortgage payments.
Additionally, inflation also affects the equity market. Higher interest rates are almost certainly associated with lower stock market returns, which explains why the stock markets are falling.
What causes stagflation?
Economists agree that there are two root causes of stagflation: supply shocks and fiscal monetary policies. A lack of commodity or product supply, combined with a Fed policy of raising interest rates, can result in inflation and a slowing economy, both of which are classic signs of stagflation.
The high inflation will force the Fed to tighten the monetary policy by raising the interest rate. A tighter monetary policy reduces the consumer demand for goods and services. Furthermore, the higher interest rates discourage people from purchasing big items such as houses and cars. From the business perspective, the increasing interest rates highly affect capital spending and inventory. Companies will slowly stop hiring and eventually lay off their workers to cut costs.
According to Jonathan Wright, an economics professor at John Hopkins University, stagflation could occur if a recession occurs before inflation has reached the Fed’s target level. As an illustration, if the unemployment rate rises to 6% and consumer price index inflation is also above 6% in 2023, that would be a form of stagflation, although not to the extent of what happened in the 1970s.
The duration of stagflation is commonly measured by quarters (months) rather than years. The longest stagflation happened in multiple economies from 1973 to 1982. During stagflation periods, there is an increased risk of people becoming jobless and having low salaries, weakening consumer confidence. Furthermore, businesses will suffer from higher costs and lower sales, which may reduce revenue and lower stock prices, affecting investors.
How can you prepare for stagflation?
Despite surveys and studies warning of stagflation, not everyone believes it will happen nearly. However, it is worth preparing for the worst. Before anything worse happens to the economy, it is a good time to revisit your financial plan.
Starting with preparing at least six months’ worth of emergency funds in case of a downturn. Also, make sure you have a budget to save money in any areas that suit your risk profile.
In addition, look at any adjustable rate of debt you may have, such as credit cards and loans. See if you can reduce or refinance the balances. With interest rates on the rise, those balances will become more expensive. Furthermore, if layoffs become the norm, now is a great time to invest in yourself to become more marketable professionally.
Although stagflation or recession is still a forecast, make sure you have prepared yourself personally and financially. In that sense, you may be able to survive during a bad economy.
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