Stagflation is an economic phenomenon marked by slow economic growth and rising prices. In the 1970s, the phenomenon hit hard, as rising inflation and slumping employment put a damper on economic growth. As a result, for investors in equity markets, "stagflation" can be a hard word to hear. In this article, we'll take a look at how stagflation is measured, what factors contribute to it and how to protect your finances.

How Is It Measured?

Stagflation is not measured by a single data point, but rather by examining the direction of a variety of indicators over an extended period of time. While the direction of a single indicator does not necessarily indicate the potential for or the presence of stagflation, when the indicators are considered in aggregate, a picture of the economy's health emerges. When an increase in certain indicators occurs over a long period of time and is coupled with declines in other indicators, stagflation is said to be occurring.

When "Up" Is a Bad Sign

Rising prices and rising unemployment are two of the data points used in attempts to determine whether stagflation is threatening the economy. While hikes in the cost of food, energy or other individual items are generally not perceived as signs of stagflation, a broad-based rise in the cost of goods and services is something to be concerned about. There are several ways to track such rises, including monitoring 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." When the CPI number is rising, fears of inflation come to light. The Federal Reserve likes to see the CPI rising at a rate of less than 2% per year. 

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

When "Down" Is a Bad Sign

Declines in gross domestic product (GDP) and productivity often indicate 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 healthy economies, 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 revenues and other GDP components such as business inventories. Productivity measures may be examined collectively across the whole economy or viewed individually by industry to examine trends in labor growth, wage levels, and technological improvement. Declining productivity is generally a sign of an unhealthy economy.

Why It Happens and How to Fix It

There are multiple theories about why stagflation occurs. Some of the major concepts are those put forth by Keynesian, monetarist and supply-side economists.

Keynesian economists blame supply shocks for causing stagflation. They cite surging energy costs or surging food costs, for example, as the cause of economic woes. Monetarists cite overly rapid growth in the money supply for causing too many dollars to chase too few goods. Supply-siders blame high taxes, excessive regulation of businesses and a persistent welfare state that enables people to live well without working.

Still others theorists argue that stagflation is simply a natural part of the business cycle in modern economies or that politics or social structures are to blame. The failure to forecast, avoid, and contain stagflation as it appears and disappears in various parts of the global economy suggests that the true answer may not yet be known.

An effective method of addressing stagflation once it occurs is equally elusive. During the 1970s stagflation persisted in the U.S. despite the government's best efforts to contain it. The trend was finally broken when the Federal Reserve hiked 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 Yourself

A sound, a long-term financial plan is the best way to protect yourself from the ravages of stagflation. But don't panic and sell your stocks and bonds to invest in rare art, gold, Beanie Babies, or some other unusual commodity; stagflation is not a good reason to completely abandon a sound investment strategy. On the other hand, if your portfolio is tilted toward aggressive investments or is not well-diversified, it may be time to add a little caution to your investing.

Bottom Line

If you have been living within your means, stagflation should have no major impact on the way you live your life. While you might delay making large purchases such as a new home, particularly if the area where you live is experiencing a real estate bubble, this is just intelligent shopping behavior. Looking for a bargain is something you should do all the time, not just when times are tough. If you've got a job and have money to spend, spend it. If you're saving and investing, keep right on doing it. There's no need to make drastic changes to the way you live your life just because the economy is in flux.