How to Protect Your Finances From Stagflation

Stagflation, or recession-inflation, is an economic phenomenon marked by persistent high inflation, high unemployment, and stagnant demand in a country's economy. During a particularly severe period of economic conditions in the 1970s, rising inflation and slumping employment put a damper on economic growth in the United Kingdom and seven other major market economies, and investors in equity markets suffered greatly as a result.

After Iain Macleod, a British Conservative Party politician, used the term stagflation during a speech to Parliament in 1965, it was adopted by the media who began using it when referring to the economic conditions that were impacted the country from 1973 to 1982. The term stagflation is a portmanteau of the words stagnation and inflation. Since then, economists have studied what factors lead to stagflation and developed methods for measuring it. Their findings also include practical suggestions for how investors can protect their finances during periods of stagflation.

How Is Stagflation Measured?

Stagflation isn't measured by a single data point, but rather by examining the direction of a variety of indicators over an extended period of time. Rising prices and rising unemployment are two of these data points. The direction of a single one of these indicators does not necessarily indicate the potential for, or the presence of, stagflation. Rather, the phenomena are considered in aggregate.

Increase in the Cost of Goods and Services

An increase in the cost of food, energy or other individual items is generally not perceived as a sign of stagflation. However, a broad-based rise in the cost of goods and services can be an indicator. Investors who want to anticipate these increases can monitor trends in the Producer Price Index (PPI) and the Consumer Price Index (CPI).

The PPI measures the average change in selling prices received by domestic producers of goods and services over time. From an investment analysis perspective, it is very useful for analyzing potential sales and earnings trends in a variety of industries. From an economic analysis standpoint, movements in the PPI show whether the cost of producing goods is rising or falling. 

The CPI measures the weighted average of prices of a basket of consumer goods and services. When tracked over time, the CPI provides insights into the direction consumer prices are headed. The CPI is often referred to as "headline inflation." A normal rise in the CPI is less than 2% per year. When that number rises beyond that, investors begin to fear inflation.

Price increases aren't the only rising indicator that suggests the possibility of stagflation. A rising unemployment rate is another indicator.

Decline in Productivity

A decline in the gross domestic product (GDP) and productivity are both indicators of an ailing economy. GDP tracks the monetary value of all the finished goods and services produced within a country's borders in a specific time period. In a healthy economy, this number is generally rising. Productivity is an economic measure of output per unit of input. Inputs include labor and capital, while the output is typically measured in revenue and other GDP components, including business inventories.

Productivity measures may be examined collectively across the whole economy, or they may be viewed individually by industry to examine trends in labor growth, wage levels, and technological improvement. Declining productivity is generally a sign of an ailing economy.

Why Does Stagflation Occur?

There are multiple theories about why stagflation occurs put forth by Keynesian, monetarist and supply-side economists.

Keynesian economists blame supply shocks for causing stagflation. For example, they cite surging energy costs or food costs as the root cause of the economic problems of stagflation. Monetarist economists cite too rapid growth in the money supply for creating a situation where there are too many dollars chasing too few goods. Supply-side economists blame high taxes, excessive regulation of businesses, and a persistent welfare state that enables people to survive without working. Additional theories exist that stagflation is simply a natural part of the business cycle in modern economies or that politics or social structures are to blame for stagflation.

The failure to forecast, avoid, and contain stagflation once it occurs suggests that the exact forces that create stagflation are not yet known. An effective method of addressing stagflation once it occurs is also unknown. During the 1970s stagflation persisted in the U.S. despite the government's best efforts to quell it. The trend was finally interrupted when the Federal Reserve raised interest rates to the point where borrowing was impossible for many segments of the economy, and the country fell into a deep recession.

How to Protect Your Finances From Stagflation

A sound, a long-term financial plan is the best way to protect your finances from stagflation. If you have been living within your means, stagflation should have no major impact on the way you live your life.

When stagflation does occur, don't panic and sell your stocks and bonds and invest in rare art, gold or other unusual commodities. Stagflation is not a good reason to completely abandon a sound investment strategy. However, if your portfolio has more aggressive investments or is not well-diversified, it may be time to decrease your risk.

Stagflation may also be a reason to delay making large purchases, such as buying a home, especially if the area where you live is experiencing a real estate bubble. However, if you are employed and have money to spend, you should continue making regular purchases. You should also continue your saving and investing habits.