👨‍🎓 Stagflation - the worst of both worlds

12/52 Macro Mornings Education

Nov 18, 2024

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👨‍🎓 This is part of a 52-week series on macroeconomics designed to build your knowledge step by step. Feel free to catch up on previous emails here if you'd like to start from the beginning!

Dear all,

We’ve explored inflation, deflation, and even the extreme case of hyperinflation. But what happens when an economy experiences the worst of both worlds - rising inflation and stagnant economic growth?

This phenomenon is known as stagflation, and it’s one of the most challenging economic conditions to navigate.

Stagflation is characterized by three key features:

High Inflation: Prices for goods and services rise rapidly, eroding purchasing power.
Stagnant Economic Growth: The economy isn’t growing or is growing very slowly, leading to weak job creation and wage stagnation.
High Unemployment: Despite rising prices, job opportunities are scarce, leading to higher unemployment rates.

Stagflation is particularly difficult for policymakers because the usual tools for combating inflation (like raising interest rates) can further harm economic growth and employment.

Conversely, measures to stimulate the economy (like lowering interest rates or increasing government spending) can exacerbate inflation.

One of the most famous examples of stagflation occurred in the 1970s.

The decade was marked by high inflation, driven in part by oil price shocks, alongside slow economic growth and rising unemployment.

This created a situation where traditional economic policies failed to address the underlying problems effectively.

For individuals, stagflation poses several challenges:

Erosion of Purchasing Power: As prices rise and wages stagnate, your ability to afford goods and services declines. This can lead to a decrease in your standard of living.
Investment Dilemmas: Traditional assets like stocks may struggle in a stagflationary environment due to weak corporate profits and economic stagnation. Bonds might also underperform as rising inflation erodes their real returns.
Increased Financial Uncertainty: High unemployment and economic stagnation can lead to job insecurity, making it harder to plan for the future.

So, how can you protect yourself during stagflation? Here are a few strategies:

Invest in Commodities: Commodities, particularly oil and gold, have historically performed well during periods of stagflation. For example, during the 1970s, gold prices soared as investors sought a hedge against inflation and economic uncertainty.
Consider Inflation-Linked Bonds: As we’ve discussed in previous emails, inflation-linked bonds, like TIPS in the U.S., can help protect your portfolio from rising prices.
Diversify Globally: Different countries experience economic conditions differently. By diversifying your investments across various regions, you can reduce your exposure to stagflation in any one economy.
Focus on Essential Goods and Services: Companies that provide essential goods and services (like utilities, healthcare, and consumer staples) tend to be more resilient during stagflation, as demand for their products remains relatively stable.

Stagflation is a challenging environment, but by understanding its dynamics and taking proactive steps, you can help protect your wealth and navigate these difficult times.

In our next email, we’ll transition to a new topic - interest rates - and how central banks use them to manage inflation and economic growth.

Alessandro
Founder of Macro Mornings

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