What is Stagflation?
Stagflation is a relatively new word. Its first known usage was in 1964 by British politician Iain Mcleod. It described a very new, very dangerous economic problem where prices and unemployment increased simultaneously.
But honestly, we don’t talk about it much. It’s very rare and requires a perfect storm of conditions to occur.
Lately, however, people worry that post-pandemic conditions might create that perfect storm again.
But is that true? What conditions create this “perfect storm?” And how might stagflation affect us and our retirement plans?
What is stagflation?
The term “stagflation” is a portmanteau of the words “stagnant” and “inflation.” It’s a perfect description: stagflation occurs when high inflation, slow economic growth, and high unemployment rates happen simultaneously over a sustained period. Stagflation is also sometimes referred to as “recession-inflation.”
In other words: stagflation happens when things become increasingly expensive while fewer and fewer people can afford the new, higher prices.
While these are the generally agreed-upon conditions, stagflation actually has no specific definition or parameters. This is partially because it’s so rare—so far, the United States has only experienced a major, sustained period of stagflation once, in the 1970s.
What causes stagflation?
Until the 1970s, many thought stagflation was impossible. That’s because policies that increase unemployment typically reduce inflation and vice versa. For instance, when the economy booms, demand for products typically rise—and, with it, prices. This helps businesses afford to hire more employees, reducing unemployment. During a recession, demand goes down. Prices are lowered, and unemployment goes up.
But in the 1970s, a few things came together to cause both inflation and unemployment to rise:
Supply shocks are disruptions to a supply chain that increases product scarcity. When products become more scarce, the price increases. These shocks can be caused by unexpected global events that lower production (such as a pandemic) or an unexpected destruction of goods (such as an extended drought killing off crops).
In the 1970s, a heightened political climate led to oil embargoes. Suddenly, the United States’ supply of crude oil went down. As a result, prices for gasoline and other oil-reliant products and services (shipping, energy, etc.) skyrocketed. By the end of the decade, gas prices had nearly quadrupled.
A recession is a sustained period of negative economic growth. A common effect of a recession is an increase in unemployment rates.
The 1970s saw two major recessions: from 1974-75 and from 1979-82. According to the Bureau of Labor Statistics, unemployment from 1970-74 averaged 5.4%. By the end of the decade, it had increased to over 8%.
Price stability requires a low and steady inflation rate. This makes pricing predictable for both businesses and consumers. Price instability occurs when the inflation rate spikes up and down in unpredictable ways, which makes it more difficult to plan around coming changes accurately.
During the 70s, prices ping-ponged from year to year. Businesses couldn’t keep up and consumers were incapable of understanding how much money they’d need in the future.
Federal reserve policy
The policies of the Federal Reserve can alternately affect inflation and unemployment. When faced with high unemployment, the Fed often lowers interest rates. This makes borrowing money easier for businesses by lowering the interest they’d owe. This gives businesses access to more money, which they can then use to hire and train new employees.
The Fed fights high inflation by raising interest rates. This makes it more difficult for businesses to borrow money, which can reduce their ability to produce and purchase goods and services. Demand for these goods and services goes down—and, ideally, prices.
Faced with stagflation in the 70s, the Fed battled inflation and unemployment separately. They’d fight unemployment by lowering interest rates. When inflation rose, they’d raise the rates. Unfortunately, inflation and unemployment consistently rose together, making the Fed’s policies ineffective in the fight.
How can inflation and stagflation impact retirement?
Whether you depend on investments or simply save your money, inflation can have serious impacts on your retirement plans. Sustained periods of inflation, such as during stagflation, can have an even bigger impact. This is because inflation:
Decreases spending power
Preparing for retirement requires understanding how much money you might need to sustain yourself for 15 or more years.
But inflation drastically affects your spending power. Even with a steady inflation rate, the dollar’s value typically decreases year-to-year, eroding the value of your savings. In 2022, inflation reached over 8%—and the value of your retirement savings decreased accordingly.
When preparing for retirement, it’s helpful to allow for inflation increases over the years—with maybe a little extra on top to account for unexpectedly high or sustained inflation.
Unfortunately for those living on a fixed income, inflation can cause significant price increases. This is enough of a problem on its own, but it can get worse depending on which industries get hit hardest.
Though the specific industries inflation will affect most is difficult to predict, it usually eventually increases prices for housing and healthcare. This can be a big problem for retirees, who typically spend a higher percentage of their income on these two industries than non-retirees do.
Lowers stock value
Not only does sustained inflation diminish the dollar’s value, but it also decreases consumer spending. A stagnant economy can do the same. This can lead to many businesses seeing reduced profits, which can lower their stock value. Most popular retirement plans (such as 401k plans and IRAs) are diversified stock investment plans. If these stocks go down, so too does your retirement savings.
The further you are from retirement, the more time you have to make up for these losses. That’s because retirement investments are designed for slow, steady growth. Depending on the current market, you can maneuver your investments to avoid major losses and recover once stagflation has passed—something I learned during the Great Recession.
If you’re close to retirement, you also have some late-in-life investment options that can help you maximize your savings in the last decade or so before you retire.