You don’t need to be an economist to know that when inflation sets in, your money doesn’t go as far. In simple terms, inflation is an overall increase in prices — whether you’re at the grocery store, the mall or shopping from your favorite online retailer.
When rising prices are accompanied by a slowing economy and high unemployment, you can end up with stagflation instead. Understanding stagflation vs. inflation can help you feel more confidence when you invest during changing market cycles.
What is inflation?
Inflation is an increase in the price of consumer goods and services over time. The Bureau of Labor Statistics (BLS) uses the Consumer Price Index (CPI) to track the rate of inflation. The CPI measures the average change of prices over time that you pay for a variety of goods and services, including things like gas, food and housing.
So, what causes inflation? And is all inflation the same?
At the heart of higher inflation: An increase in the money supply (that’s the total amount of cash circulating). Specifically, rising inflation can happen when growth in the money supply outpaces an economy’s ability to produce goods and services. If this happens, there are three forms inflation can take.
The most common type of inflation, demand-pull inflation occurs when aggregate demand for goods or services outweighs aggregate supply. It works like this:
- Consumer demand for a particular good or service increases
- Sellers can’t meet the initial demand with their existing supply
- If supply shrinks or becomes unavailable, sellers raise prices
In this scenario, there’s more money supply than goods or services, which pushes prices up for what is available.
This type of inflation occurs when it costs companies more money to produce the same goods and services, and they pass those expenses on to consumers in the form of higher prices.
For example, say a hurricane damages a major oil refinery that makes gasoline. If the refinery’s production or transportation costs increase, that can mean higher gas prices for you (assuming demand for the refinery’s products remains steady).
The good news is that cost push inflation tends to be short-lived — provided the reason(s) that caused prices to increase come to an end.
Built-in inflation is an expectation-driven phenomenon. This type of inflation can happen when businesses or workers assume that prices will rise sometime in the near future.
Say, for example, that a company anticipates a 2% increase in the inflation rate over the next year. It may develop a plan to raise prices for their goods and services based on that expectation. At the same time, their employees may expect higher wages for their income to keep pace with increasing expenses.
What is stagflation?
Stagflation is the combination of stagnant economic growth, high inflation and a high unemployment rate. When stagflation sets in, consumer spending slows down. Higher prices may continue, even when demand slows and you’re purchasing fewer goods and services. This can cause a downward spiral, leading to economic activity slowing even more.
In the 1970s, the U.S. experienced an extended period of stagflation characterized by a 9% unemployment rate, double-digit inflation and a shrinking economy. Fiscal and monetary policy, coupled with an oil embargo which sent fuel prices skyrocketing, were the main drivers of stagflation.
In a worst-case scenario, stagflation can lead to runaway inflation known as hyperinflation. This happened in Zimbabwe in 2007, when the government opted to print more money in order to combat stagflation.
Investing During Stagflation
Stagflation is less common than inflation, but it’s important to know how you might want to invest to combat stagnant economic growth. Paying attention to inflationary movements can give you an idea of whether stagflation may be around the corner.
Look for Value
When the economy slows down, it could make sense to reallocate your portfolio to include more value stocks or cyclical stocks while moving away from growth stocks. Growth stocks are generally considered a no-go during stagflation since rising prices can erode the future value of company profits.
Stick With the Basics
Some investors like to invest in commodities or companies that produce raw materials during stagflation. Companies that produce materials needed to manufacture other goods are the price-setters, so there’s the possibility they may be more protected against market volatility when supply and demand gets out of balance.
Investing During Inflation
When price increases set in and inflation rises, your purchasing power shrinks. So, it’s important to make every dollar count in your portfolio.
Treasury Inflation Protected Securities (TIPS) adjust the principal amount to keep pace with inflation. When higher inflation arrives, investors may reap higher returns as a result. These investments could be a good buy if you’re looking for some protection against higher inflation over the long-term.
Dip Into Dividends
Dividend stocks are another choice to consider, though they can be a double-edged sword. These stocks can provide consistent income — but if profits shrink due to rising production costs, then dividend payouts may decrease during inflation. One alternative? Do some research on cyclical dividend stocks, which tend to fare better when prices become inflated.
Go Beyond Stocks
Stocks can help to offset the effects of inflation, but you can also consider alternatives. Investing in real estate, for example, can be a good hedge against inflation since property values tend to climb alongside consumer prices. A real estate investment trust (REIT) or real estate exchange-traded fund (ETF) are two simplified ways to invest in property without actually owning it.
Don’t let stagflation or inflation derail your portfolio.
Inflation and stagflation can be unpleasant to deal with as a consumer and an investor. But knowing how to spot the signs of both can help you adjust your investment strategy to take them into account. The most important thing is to avoid being an emotional investor and panicking in the face of changing stagflation or inflation expectations.
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