How High Inflation Can Turn Into Stagflation

America’s economic poisition is not strong at the moment. Inflation is around 8.5%, and the overall economy shrank at a 1.4% annualized rate in the first quarter. It takes two quarters of a declining economy to officially declare a recession, but the warning signs are ominous.

In addition, regardless of whether or not the economy ends up in an official recession, the combination of high inflation and low economic growth has a somewhat scary name: stagflation. Stagflation often brings with it all sorts of pain as companies strive to cut costs while consumers face ever rising prices. Unfortunately, high inflation can often turn into stagflation, and the beginning of that trend may already be underway.

Layoffs: A key sign of cost-cutting

For instance, there are early signs that companies are looking to reduce their staffing costs. Recent layoffs at Robinhood Markets, hiring freezes at Meta Platforms, and engineering cutbacks at Ford Motor Company may just be the tip of the iceberg of the challenges headed our way.

Companies generally announce layoffs when they believe the costs of keeping their people is higher than the benefits they will get from doing so. As inflation raises, the costs of many inputs also rise, and employees begin asking for higher wages to keep up with their own rising costs — and businesses face little choice but to look for ways to cut their costs.

During inflationary times, the employees that remain might get a salary boost, but that boost comes at the cost of either doing or shutting down the work of their newly departed coworkers. And while the company might lower its total costs thanks to having fewer employees, it might find it harder to grow as fast as it otherwise would have.

When a single company makes a choice like that, it might be good for its near-term bottom line. When companies across wide swaths of the economy make that same choice, that can lower overall economic growth. That stagnation is where the “stag” part of the “stagflation” term comes from.

Inflation: Forcing tough consumer choices

In addition, the way this particular wave of inflation is roaring through the economy, it is forcing people to make tough choices. Although the overall inflation rate is 8.5%, food inflation is even higher at 8.8% and energy inflation is at an astonishing 32%. The thing about food and energy is that while it’s often possible to conserve energy and make different choices about food, those are ultimately unavoidable costs in people’s lives.

Unless a person’s salary is keeping up with those elevated costs, they must make choices on where to spend their limited available resources. When forced to make choices like that, most people will scale back to the core — keeping things that matter the most to them and cutting out the things that don’t.

A drop in consumer demand is the definition of a slowing economy. Or yet again, from a different direction, high inflation leads to stagnation.

Image source: Getty Images.

What can you do about it?

To make it through successfully, first, you need to make sure your own financial house is in order. If you can pay off your high-interest rate debts, pay them off. If you can’t, figure out how to refinance what you can into lower — and if possible, fixed — rates, and use the debt avalanche method to pay those debts down as quickly as you can.

To use the debt avalanche method, line up your debts in order from the highest interest rate to the lowest interest rate. On all your debts except the highest-rate one, pay the minimum. On the highest-rate debt, pay down as much as you can above and beyond that minimum until it’s paid off. Then, put the money you had been putting toward that debt to your new highest rate debt. Repeat until (nearly) all your debts are paid off.

It might be OK to keep some debt, even while investing. If you do so, recognize that the debt remains an obligation that you need to pay, even if money is otherwise tight. Also recognize that stocks don’t always go up, so you may not have a good opportunity to liquidate your stocks to make your debt payments if push comes to shove.

Once your debts are in control, make sure you build an emergency fund of three to six months of your expenses in cash-like assets. This is particularly important if you find your job eliminated as a result of either corporate cost-cutting efforts or of consumer cutbacks as other people seek to reduce their spending.

In an inflationary environment, be careful not to over-save, however, as returns on cash tend to trail inflation, meaning that money will lose value over time. An emergency fund is meant as a short-term source of cash, just in case, not a long-term sustainable source of spending money.

With your debts under control and an emergency fund in place, feel free to invest in ways to try to beat inflation over time. Just remember that investing is a long-term process, and it may take time for the market to recognize the true value of the businesses you’re buying.

Get started now

High inflation and slow economic growth often combine to create both a rough stock market and job market. This may be your last best shot to get yourself prepared, so take it while you can. If you do find yourself directly impacted by the negative consequences of stagflation, you’ll be glad to be prepared. If you manage to make through unscathed, you’ll still be set up with a solid foundation for your future. So get started now, and improve your financial flexibility to help you through whatever comes your way next.

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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Chuck Saletta has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Meta Platforms, Inc. The Motley Fool has a disclosure policy.

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