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What Is Stagflation? And How Does It Work?

If you want to send shivers down an economist’s spine, all you have to do is say one strange-sounding word—stagflation.

Nope, we’re not talking about a boom in the population of male deer. Instead, we’re talking about an economic term that is used to describe an unlikely combination of economic conditions: a stagnant (or struggling) economy and a rise in the price of goods and services across the board (also known as inflation).

So when you pair economic stagnation along with rapidly rising inflation, you get . . . stagflation! Get it?

While we haven’t seen this demoralizing one-two punch since the 1970s, more and more economists are sounding the alarm that we might be heading toward another period of stagflation in the aftermath of the COVID pandemic.

But first, let’s take a look at what stagflation is, what causes it, and look back at the history of stagflation before trying to figure out whether or not history will repeat itself. 

What Is Stagflation?

Stagflation is an economic term that describes what happens when economic growth slows down or stops altogether, unemployment is high, and the price of goods and services keeps rising—all at the same time.

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Why is stagflation a bad thing? When you have a stagnant economy and out-of-control inflation happening at the same time, it creates a nasty cocktail of economic conditions that could leave everyone feeling a bit woozy. Not only do folks have less money to spend, but the value of the money they do have takes a hit because it won’t be able to buy as much as it used to. 

What Are the Causes of Stagflation?

There are lots of theories out there about why stagflation happens and what the causes are, but they mostly boil down to two factors when you get through it all: bad government policies and sudden changes in the supply of an important commodity like oil.

Government Policy

Sometimes, when the government tries to get involved in something, they end up making things worse. Shocking, we know.

In an effort to get the economy moving, governments might try to increase the money supply by printing more money or by making it easier to borrow money. The problem is that, at some point, there might be too many dollars out there and not enough goods, which can lead to rapid inflation because the supply can’t meet demand.  

If the government decides to increase taxes and interest rates at the same time—which might slow down economic growth—that also might lead to stagflation.     

Supply Shock

Another way stagflation might rear its ugly head has to do with an unexpected decrease in the supply of an important product or commodity, especially something like oil. That’s also known as “supply shock,” and it could spark a domino effect that leads to a sudden rise in prices throughout the economy.

Supply shortages often make it more expensive to produce certain goods and to transport them from place to place. To make up for those rising costs, companies might raise the price of what they’re selling, lay off some of their employees, or a combination of both.

Examples of Stagflation

For the longest time, people thought stagflation wasn’t really possible. After all, how can prices go up if the economy was stalled or even shrinking? When people have less money to spend, consumer demand drops . . . and usually prices drop with that falling demand. Makes sense, right?

But then the 1970s happened. While disco and bell bottom jeans were all the rage, there was a toxic combination of events and economic factors that led to a period of stagflation (dun-dun-dun). 

Here’s what happened. In the early 70s, oil prices skyrocketed and that made it more expensive to produce goods and transport them where they needed to go, which had a devastating ripple effect on the overall economy. Those rising oil prices, along with a series of other supply shortages, led to rapid inflation along with a global recession—which meant that prices for everything from milk to gasoline were going up, up and up while more and more Americans found themselves out of work.

The Federal Reserve tried to solve the problem by pumping more money into the economy and cutting interest rates. The thinking was that these actions would make it easier for folks to borrow money and spend it, boosting economic growth in the process.

But there was a problem: Businesses simply weren’t able to produce enough goods and services to meet the rise in demand, so all that extra money only made things more expensive.

With businesses expecting the costs of production to rise, they started laying off workers. As more and more workers made their way to the unemployment line, the United States went through a couple of nasty recessions and a period marked by “malaise.”

It wasn’t until the early 1980s, when the Federal Reserve—under new Chairman Paul Volcker—cut the money supply and raised interest rates dramatically in an attempt to make it more expensive for businesses and individuals to borrow money and stop inflation in its tracks. At first, those actions caused some short-term pain—economic output dropped and unemployment hit 10%.

But something really important happened: Prices stopped rising and the economy gradually recovered and the balance of supply and demand was restored, ending this era of stagflation once and for all.

Are We Heading Toward Another Era of Stagflation?

A lot of economists are wondering aloud whether or not we’re heading toward a rerun of stagflation, something we haven’t seen in almost half a century.

With inflation rearing its ugly head again and the economy still in recovery mode in the aftermath of the pandemic caused by COVID-19, it’s easy to understand why these fears are popping up. After all, 3 out of 4 Americans say they’ve been paying higher prices for things they normally buy, according to our Ramsey State of Personal Finance Report

But when you dig down a little deeper, you’ll see that the circumstances surrounding what’s happening now and what was going on in the early 70s are very different.

Back then, it was oil prices that caused prices to skyrocket and threw a monkey wrench in the entire economy. This current flare-up of inflation has been spurred on by a surge in demand sparked by an economy that is starting to open up post-pandemic. That has caused a supply-chain bottleneck—meaning that things are backed up because businesses are struggling to produce enough goods to meet demand—and it’s a problem that most economists believe will sort itself out over the next year or so as production continues to catch up.  

So the bottom line is this: While there might be a slight chance stagflation could make an unwanted comeback, it’s more likely that this recent bout of inflation is temporary and will eventually fade as the supply chain catches up with the rest of the economy.

How to Combat Stagflation

Whether or not stagflation is happening, there are things you can do to try and fight off the rising tide of inflation and the struggles of an economy that’s stalling more than that old beater car you drove in college. Here’s a quick list of what you can do right now to help you weather the storm!

1. Don’t panic.

Before you start stocking up on toilet paper (again) or buy up every bag of flour you can get your hands on at the grocery store, take a deep breath and remember that the economy struggles from time to time. Inflation is just a natural part of the economic circle of life, and hyperinflation doesn’t last forever.

When you start listening to all the Chicken Littles on the news and get swept away by fears of stagflation, inflation, deflation, or any other scary economic term that ends in “flation,” you might end up making financial decisions out of fear . . . and that never ends well.

2. Adjust your budget.

You can’t control what it costs to fill up your car or buy a gallon of milk, all you can do is adapt to the reality of the situation you’re living in. When you sit down at the dining room table with your spouse at the beginning of the month to talk about your budget, it might mean having some tough conversations about cutting back on other areas like dining out or entertainment to make up for the rising costs of essential budget items like gas and groceries.

3. Look for ways to save.

Do you have a coworker you can carpool to work with? Can you switch to generic brands on some grocery items? Are there any subscriptions or streaming services you barely use that you can cut? It might not seem like much, but all those small steps can add up to big savings over time as you try to stretch your money out further.

4. Invest to stay ahead of inflation.

Inflation might hurt a little bit now, but inflation will really hurt you 20 or 30 years down the line if you are not staying ahead of it. How do you stay ahead of it? By investing in mutual funds that will help your money grow beyond the rate of inflation. Historically, inflation increases the price of goods and services by around 3% each year.1 Meanwhile, the stock market has an average annual rate of return between 10–12%.2

So if you’re out of debt with a fully funded emergency fund in place, then it’s time to start investing in good growth stock mutual funds that can help you save for retirement and keep you ahead of inflation!

Worried About Stagflation? Talk With a Financial Advisor

There are a lot of things that are out of your control. You can’t control the rate of inflation. You can’t control gas prices. And you can’t control whether or not stagflation is going to happen.

But what you can do is make the decision to save and invest your money month after month, year after year, knowing that doing so will help you reach your retirement dreams 10, 20 or maybe even 30 years from now—regardless of what’s happening with the economy right now.

And the best way to help you stay on track is to work with a SmartVestor Pro. We can connect you with RamseyTrusted financial advisors who are committed to helping you set up a plan to invest for the future and keeping you on track whether the economy is on a roll or in the dumps.

Find your SmartVestor Pro today!

Ramsey Solutions

About the author

Ramsey Solutions

Ramsey Solutions has been committed to helping people regain control of their money, build wealth, grow their leadership skills, and enhance their lives through personal development since 1992. Millions of people have used our financial advice through 22 books (including 12 national bestsellers) published by Ramsey Press, as well as two syndicated radio shows and 10 podcasts, which have over 17 million weekly listeners.

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