Inflation vs. Stagflation vs. Deflation: What's the Difference?

It’s impossible to turn on the news in 2022 without hearing about inflation. The rapid increase in the Consumer Price Index and the subsequent loss of spending power is monopolizing the headlines and affecting all of our lives.

Our Addition Financial members often ask us about inflation vs. deflation vs. stagflation. These terms may be confusing and it’s important to understand the difference and the effect that each can have on your money. Even if you have a general idea of what these terms mean, we thought it would be helpful to explain them. Here’s what you need to know.

What is Inflation, Deflation, Stagflation?

We’ll start with some definitions to help you understand the similarities and differences between inflation, deflation and stagflation.

What is Inflation?

Inflation is a measurement of the increase in prices over a period of time. In the United States, inflation is calculated using a “basket” of goods and services that includes items such as housing expenses and food. The Bureau of Labor Statistics (BLS) includes over 94,000 items in the basket and collectively, the cost of these items is referred to as the Consumer Price Index (CPI).

Inflation over the course of a year would be calculated by taking the CPI at the end of the year and dividing it by the CPI at the beginning of the year. The resulting number, expressed as a percentage, is the inflation rate.

There are multiple types of inflation. Here are two of the most common:

  • Cost push inflation occurs when production of goods is reduced because of increases in the cost of production.
  • Demand pull inflation may be caused by increased government spending, an expanding economy or overseas economic growth.

Cost push inflation is the most common cause of inflation and is the cause of the inflation we are experiencing in 2022.

What is Deflation?

Deflation is the opposite of inflation. It occurs when the CPI drops in a specified period of time. As prices decrease, the purchasing power of a dollar increases.

When we’re in a period of inflation, deflation might seem like a desirable thing. However, it can be a harbinger of an economic downturn or recession. 

The most famous example was after the infamous stock market crash in 1929. In the three years following the crash, prices dropped by an average of 7% per year. The deflation was caused by the collapse of banks and markets, but it played a role in worsening and prolonging The Great Depression, which lasted until 1939.

What is Stagflation?

Stagflation is a term that refers to a combination of slow economic growth and inflation. The “stag” part of the word refers to a stagnant economy. Economic growth is measured using the Gross Domestic Product or GDP of the United States. In a stagnant economy, the GDP either remains unchanged or grows at a rate that’s slower than normal. 

What Are the Effects of Stagflation?

Stagflation can impact consumers in a variety of ways. It is not uncommon for stagnation to be a precursor of recession, and economic stagnation may also be accompanied by rising unemployment rates.

Here are some of the specific effects of stagflation:

  • People earn less money and the money they earn has less purchasing power than it would in a period of normal inflation.
  • Consumer prices increase which can lead to decreased buying and exacerbate stagnation or even lead to economic shrinkage.
  • As consumer spending slows, corporate profits shrink, and that can lead to layoffs and a high unemployment rate.
  • High inflation can impact the stock market since it can lead to distorted thinking among investors.
  • Bond prices typically decrease as do equity valuations.

As you can see, stagflation can be disastrous for the economy.

free inflation infographic

What is the Difference Between Stagflation and Recession?

As we noted above, stagflation refers to a period of slow economic growth plus high inflation. A recession occurs when there are two successive quarters of negative economic growth. A recession is typically also accompanied by high unemployment.

High inflation and/or stagflation don’t always lead to a recession. However, when inflation is high and economic growth is slow, the combination of a lower GDP and high prices can lead to high unemployment and ultimately, to a recession.

Should You Be Worried About Stagflation?

Many of our members have been asking us about stagflation and if it’s something they should be thinking about in 2022. Here’s what you need to know.

The CPI increased by 9.1% between June of 2021 and June of 2022, so the inflation rate in June of 2022 was 9.1%. As a point of comparison, in most years inflation ranges from 1.5% to 4%. By any measure, 9.1% qualifies as high inflation.

The Gross Domestic Product (GDP) of the United States dropped 1.6% in the first quarter of 2022. A second quarter of GDP shrinkage would mean that the country is officially in a recession. Some estimates indicate that the second quarter numbers might show economic shrinkage of as much as 2.1%.

Both recession and stagflation may also be characterized by high rates of unemployment, something that’s not an issue as of August 2022. However, poor economic performance and high inflation could impact employment.

In terms of worry, our advice is to keep an eye on economic numbers and do what you can to protect yourself. We’ll get into some specific advice in the next section.

Tips to Protect Your Money and Investments from Stagflation

While no individual has the power to prevent stagflation, there are some things you can do to protect your money and investments – including your retirement savings – from stagflation.

Evaluate Your Stock Portfolio

If you have a stock portfolio, then approaching stagflation is an opportunity to evaluate your portfolio. Stocks typically outperform bonds, so it’s not a good idea to sell unless you need to address a lack of diversification in your portfolio.

You may want to consider adding dividend-generating stocks or mutual funds to your portfolio, since they generate income while you wait for stock values to increase. Exchange-traded funds are also a good option since they allow you to spread your risk across multiple stocks.

Pay Down Debt

Interest rates are still relatively low, so you may want to review your debt and create a plan to pay down what you can. We recommend beginning with any debt that isn’t fixed at a low interest rate. 

Keep in mind that anything with a variable interest rate may be subject to increases in interest rates in the future. That’s just as true of credit card debt as it is of lines of credit with variable rates.

Invest in TIPS

Treasury Inflation Protected Securities, or TIPS, have value that rises and falls with the Consumer Price Index, which means that investing in them will guarantee that your money doesn’t lose buying power in times of high inflation.

When a TIPS bond reaches maturity, you will be paid one of two totals: the adjusted principal or the original principal. Said another way, you won’t lose money in times of inflation or deflation because, at minimum, you’ll be guaranteed to get your original principal back.

Invest in Real Estate Investment Trusts

Real estate prices, including rent, tend to increase in times of inflation. That can make real estate a worthwhile investment, but buying real estate renders your assets illiquid. For that reason, we recommend investing in Real Estate Investment Trusts (REITs) instead.

REITs consist of companies that own real estate, including commercial and residential properties. You can easily diversify your REIT investments by choosing an REIT exchange-traded fund (ETF) such as Vanguard Real Estate ETF.

Keep Cash on Hand for Emergencies

In periods of stagflation, having cash on hand is essential because it can protect you even if your investments don’t perform as well as you thought they would. It can also serve as an emergency fund if you lose your job or if your pay or hours are cut.

We suggest the following options to keep your cash accessible and earning money:

  • High-yield savings accounts
  • Money market accounts
  • Certificates of Deposit (CDs)

Specifically, you should buy shorter-term CDs. That way, you can roll your money into a CD with  a higher yield when interest rates rise again. (Rates are low in August of 2022 and you don’t want to be locked into a low return for the long-term.)

On a related note, it’s recommended to review your total savings. With inflation high, the amount you have saved won’t have the same buying power that it did when inflation was in the normal range. You should have six months’ worth of savings, so we suggest recalculating your monthly expenditures for rent/mortgage, utility bills, groceries, insurance and transportation. If you don’t have enough to cover you for six months, contribute more to savings until you do.

In times of economic uncertainty, it’s essential to understand financial terms such as inflation, deflation and stagflation. You can use your newfound knowledge to take advantage of the tips we’ve included here to protect yourself and your family from stagflation.

Are you looking for options to keep cash on hand? Addition Financial is here to help! Click here to learn about our Term Share Certificates.

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