What is stagflation: Understanding & navigating economic uncertainty

Typically, a high gross domestic product (GDP), low unemployment, and a slow but steady rate of inflation are all signs of a healthy economy.

Meanwhile, a falling GDP, high unemployment rates, and rising inflation can often signal trouble. You ordinarily wouldn't see all three at once. When you do, the economy is considered to be in a state of stagflation.

Stagflation is a combination of a motionless economy, increasing prices that mean your money buys less than it once did (aka inflation) and rising unemployment. It's an unusual mix because high inflation often accompanies economic expansion while a slow economy usually caps or lowers inflation pressure. Because of these unique conditions, stagflation causes and effects can be difficult to pinpoint, making it challenging to prevent or solve it.

The United States last experienced significant stagflation in the 1970s. It was largely the result of a sudden rise in oil prices that increased the costs of a broad range of goods and services without boosting economic growth.

Before getting into how stagflation was handled historically, though, let's get a better understanding of the factors that can cause stagflation.

The GDP, the unemployment rate and inflation are the key indicators that help experts assess the state of the economy. The Federal Reserve focuses on those three aspects when making monetary policy decisions, such as whether to raise or lower the federal funds interest rate.

Here's what those terms mean:

1. Gross domestic product. The GDP is the dollar value of goods and services produced within the borders of the country during a certain timeframe, normally a year. Government financial experts use this to measure the overall size of the economy. A larger GDP means the economy is producing more and is a sign of high economic activity. 

2. Unemployment rate. This rate is the percentage of people across the national workforce who are not currently working but are actively looking for jobs. High unemployment means that too many people are out of work. Unemployment isn't only bad for those who aren't earning an income—it also weighs down the overall economy because unemployed people often aren't spending money to spur the economy. 

3. Inflation. Inflation is the general increase in prices across a variety of goods and services, which then decreases the value of money. It's often described as too many dollars chasing too few goods. As with unemployment, a slow and steady rate of inflation is preferred. High inflation can signal that the economy is expanding too quickly, placing upward pressure on prices. 

Stagflation happens when all three of these factors are unfavorable—that is, when the GDP is down, unemployment is high and inflation is rising. It can be incredibly difficult for the government to solve all three issues at once. That's because the tools available to the Federal Reserve don't generally support both jump-starting the economy and lowering inflation at the same time. Consider, for example:

• Stimulating the economy to raise the GDP, create jobs and improve wages naturally puts upward pressure on prices, which can raise inflation. 

• Fighting inflation typically involves slowing down the economy to reduce pressure on prices, but that can reduce GDP and lead to declining wages and job losses. 

Essentially, combating any one of them can worsen the others, so it can be tricky to resolve. Let's look at how the U.S. has handled stagflation in the recent past.

Because stagflation is rare, there are few moments in time to study. It's not just unusual in the U.S.; stagflation is not common globally. During the most notable recent stagflation, brought on largely by the oil crisis of the 1970s, the country struggled to right the balance between unemployment and inflation rates.

Unemployment stayed well above 5% throughout the majority of the 1970s, peaking at 9% in 1975. It's worth noting, though, that more efforts to fight inflation pushed the unemployment figure even higher in the early 1980s before recovery took root. Inflation, meanwhile, climbed as high as 11%.

In retrospect, many think the Federal Reserve acted too slowly to fight inflation then and that it's what allowed the problem to grow. The Fed raised interest rates slowly in the '70s, even cutting them back in 1971 and 1972. Although the Fed began increasing the rate in 1972—peaking at almost 13% in 1974—it had fallen back to just over 5% by 1975.

This experience tells us that stagflation shouldn't be ignored because it can be very difficult to correct. By the late 1970s and early 1980s, the Federal Reserve was putting severely restrictive monetary policies in place. In 1981, the Fed's interest rate topped 19%. This pulled the economy into a recession and pushed unemployment as high as 10% by 1982. It was an unpopular move, but many ultimately felt it was necessary to curb inflation and get the economy back on track.

As the conditions suggest and history has shown, stagflation is an economy-wide issue that affects both the consumers who need to buy everyday goods and services and the businesses that sell them. The impacts are two-fold, driven by the factors that cause stagflation and the governmental policy responses that attempt to correct it.

With inflation, the prices of some goods and services will rise more than others. But the overall effect is that the cost of living goes up as people have to pay more for the things they buy. Their income suddenly doesn't go as far as far as it once did. At the same time, because of the slowing economy, businesses may not be able to afford increasing wages enough to keep up.

Purchasing power then falls, leading to a lower standard of living as people tighten budgets and cut back on purchases. Stagflation can also impact investment growth as business profits fall and inflation reduces the real rate of return.

The cause of stagflation is often a supply shock, such as it was oil prices in the 1970s. These sudden surges push supply costs up but don't come with an increase in business activity. This strains company budgets similarly to how inflation strains consumer spending. Costs can increase to as much or more than businesses can raise their prices on their goods and services, potentially cutting profits and curtailing growth. For small businesses that may already have a thin profit margin, it can put them out of business.

With reduced profitability and growth prospects, businesses are also often more reluctant to invest, or they may simply not have the funds to do so. This can slow the economy even further.

To prepare for the risk of a recession and stagflation, you need a long-term financial plan that includes a sound budget. Some specific considerations to help you protect your finances include these:

• Avoid high debt balances. If the cost of living pinches your budget, you may find it harder to make payments on costly things like a home or automobile and high-interest credit cards. Know what debt is good to have and methods for paying down balances.

• Have a short-term savings account and an emergency fund. Having money saved for a rainy day can help you weather a longer period of heightened prices or a potential job loss. 

• Plan a budget and live within your means. Try to give yourself some breathing room with a budgeting systemthat works for you. Being flexible with your spending and saving usually means less stress. 

• Educate yourself about the market. One of the best ways to be financially prepared is to know more about how inflation can affect your assets, how to invest during inflation and investment options during economic downturns.

If you find yourself facing stagflation, you'll be much better off if your finances are in order. You'll also be less likely to abandon important long-term goals, such as saving for retirement.

Stagflation financial planning doesn't have to be difficult, but you may find it easier with a little guidance. Working with a professional who has specific training and experience can help ensure your plan covers everything—and help you follow through.