Stagflation Vs Inflation

Understanding certain economic terms is essential, especially if you are an individual who wants to make profits from the changing market trends. Today, let’s talk about two terms that are of vital importance to understanding the economy: Stagflation and inflation.

You must have come across the term inflation and stagflation many times, but it is important that you understand the differences and their impact on the economy in detail to make informed financial choices. Keep reading as we discuss the details of inflation vs stagflation.

What is Inflation?

In a nutshell, inflation is the percentage of increase in the price of goods and services in the market. Every time you hear that the country is facing higher inflation, it simply means that the price of goods and services is increasing rapidly.

One of the most common signals of inflation is a consumer price index or the CPI which measures the percentage change in the price of goods and services that are regularly consumed by households.

However, remember that not every time there is an increase in goods and services the country‘s inflation rises; rather, inflation occurs when there is an imbalance between the increase in price of goods and services in comparison to the country‘s production capacity or the buying capacity.

Causes of Inflation

Let’s take a quick look at the causes of inflation:

• Demand-Pull Inflation

  As the name suggests, demand-pull simply means that the total demand for goods and services in the country is growing at a faster speed compared to the country‘s production capacity thus pushing inflation higher.

• Cost-Push Inflation

  The increase in the price of manufacturing goods and services is the cost-push cause of inflation. Now, this can be either a rise in labour expenses or raw material expenses etc.

• Built-In Inflation

  Another interesting cause of inflation is the built-in inflation. When there is a rise in the price of goods and services, the labour expects more salaries, and as their income increases, the price of goods and services in the market increases even further, creating a wage-price spiral.

What is Stagflation?

To begin with, stagflation is any situation where the economy is facing inflation paired with deceleration in the economy and persistently high levels of unemployment. Two main components of stagflation are inflation and unemployment.

Simply put, when the economy is facing a slow or stagnant growth rate accompanied by higher unemployment and reduced wages it is said that the economy is going through a stagflation.

Cause of Stagflation

Here is a list of three major causes of stagflation:

• Demand-Shock Factors

  The demand shock factor basically talks about a situation when the economy is facing a decrease in the demand for goods and services. In such a situation, the economy is meant to take a hit thus leading to a situation like stagflation.

• Supply-Side Factors

  In situations when there is a scarce or unreasonable price hike for essential commodities in the market, like oil it spurs supply-side factors. To deal with such a situation, businesses often resort to increasing the prices of these commodities, thus leaving the market in a supply-side shock eventually leading to stagflation.

• Government Policies

  In many cases there are monetary policies that look good on paper but do not work out equally well practically. This can lead to stagflation.

Stagflation Vs Inflation

Now that you have a fundamental understanding of stagflation and inflation let’s take a quick look at this table highlighting the differences between these two situations:

Historical Instance of Stagflation

Up until the 1970s, economists believed that there was an inverse relationship between inflation and unemployment. This means that as inflation rises, unemployment falls, and vice versa. However, during the 1970s stagflation emerged as a new economic situation that left economists in shock as it presented a problem when there was inflation along with unemployment and stagnant economic growth.

One of the first instances where the world saw stagflation in the economy was during the 1970s. During this period the US was facing inflation and at the same time, it had to deal with a sudden price hike in oil due to OPEC oil embargoes. Since oil is an essential commodity, the Federal Reserve had to stimulate economic growth by adopting new monetary policies. However, instead of curbing the situation these policies decelerated the economy which led to back-to-back recession in the US during the 1970s. This period is marked as one of the first times when the world saw stagflation.

A recent instance of a country facing an almost stagflation-like situation was during the pandemic when the willingness of workers to provide in-person services decreased, leading to domestically generated adverse supply shock which is one of the most common reasons for stagflation.

Over the years there have been many situations that came close to stagflation but it was only during the 1970s and the oil crisis in the US that presented a full-blown stagflation in the economy.

Impacts on Investments

Let’s take a look at the impact of inflation on different types of investments:

• Stocks

  During inflation, the purchasing power shifts thus affecting the stock market significantly. However, you must keep in mind that value stocks often tend to perform better during inflation. This is because the prices of value stocks are not based on the prices of their competitors.

• Bonds

  One of the most significant reasons that investors put their money in bonds is because it comes with a fixed interest rate. However during inflation, due to low purchasing power, the bond's future cash flow is hit hard.

• Real Estate

  Real estate is prone to facing a volatile situation during inflation this is because as inflation rises mortgage rates can also rise. An unreasonable rise in such rates often makes the general public unable to apply for loans, reducing the demand for real estate.

Strategies to Mitigate Risk

Mitigating through situations like stagflation or inflation requires the government to adopt a blend of monetary and fiscal policies. Let’s take a look at strategies that can help mitigate the risk of stagflation and inflation.

Inflation

• Hedging

  Adopting hedging in investment strategies can help mitigate the risk of inflation. Investing in things like gold or real estate is a smart choice as these assets tend to increase in value when the prices go up during inflation.

• Diversification

  One of the most reliable strategies to deal with the risk of inflation is diversification; spreading investment across different asset classes like bonds, real estate, stocks etc. Additionally, you must also keep in mind to invest in different types of assets across different industries, especially those that tend to benefit from inflationary periods.

• Inflation-Protected Investments

  There are many inflation-protected investments that you can explore and put your money in. For example, treasury inflation-protected securities or TIPS are one of the most common inflation-protected investment options.

• Avoiding Debt

  Although it is not feasible to predict inflation, it is advised to avoid excessive debt especially those with higher interest amounts. Paying off debts as quickly as possible can help stay afloat during inflammatory inflationary risks.

Stagflation

Mitigating risks during stagflation is trickier than inflation. This is simply because of the crumbling economy from every side. However, economists and financial planners argue that a blend of different types of policies can help mitigate stagflation risk.

• A reliable strategy that the US adopted during the 1970s was to amend monetary policies like increasing interest rates to tackle inflation and introducing tax relaxation and amendments in public expenditure and part of the government simultaneously.
• Encouraging reliance on stagflation-protected investments like TIPS and reducing debt to balance out interest rates can also prove beneficial.
• Reducing the reliance on commodities like oil can also help combat stagflation or stay prepared for stagflation since such commodities are at adverse risk of facing a crisis.

Conclusion

According to economists all around the globe, stagflation is considered to be an unnatural economic phenomenon, but in situations where it has occurred, it has left economists and financial planners in complete shock. On the other hand, inflation is a common economic situation that the country faces from time to time, and it can be dealt with with the right monetary policies.

Now that you have an understanding of stagflation and inflation, you are better equipped to make smart financial choices depending on the economic condition of the country. 

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