Stagflation

B is correct. During stagflation, both stocks (hurt by stagnant growth) and long-term bonds (hurt by inflation and rising rates) typically underperform. TIPS provide inflation protection through principal adjustments, commodities often rise with inflation, and reducing long-term bond duration limits losses from rising rates. This strategy addresses both the inflation and stagnation components of stagflation.

A is incorrect because stocks do NOT outperform during stagflation; corporate earnings suffer from weak economic growth even as input costs rise from inflation. C (all cash) would lock in guaranteed purchasing power losses from 8% inflation. D (long-term bonds) would be especially damaging because rising inflation typically forces central banks to raise interest rates, causing bond prices to fall while the fixed payments lose purchasing power.

B is correct. Stagflation is defined by three simultaneous conditions: economic stagnation (low or negative growth), high inflation (rising prices), and high unemployment. This combination is rare and particularly challenging because it contradicts the traditional Phillips Curve relationship suggesting inflation and unemployment move inversely.

A describes a normal expansion or overheating economy, not stagflation. C describes a deflationary recession or depression, which has falling prices (deflation) rather than the rising prices (inflation) that characterize stagflation. D describes a healthy, stable economy with the "Goldilocks" conditions central banks target.

C is correct. All three indicators point to stagflation: negative GDP growth (-0.5% = stagnation/contraction), high inflation (9.2% CPI increase), and rising unemployment (4.1% to 7.8%). This combination of economic stagnation with high inflation and unemployment is the definition of stagflation.

A is incorrect because expansion requires positive GDP growth, not contraction. B is incorrect because deflation means falling prices, but CPI increased by 9.2% (high inflation, not deflation). D is incorrect because normal recessions typically see inflation decrease as demand falls, not increase to 9.2%; the combination of contraction with rising inflation is what makes this stagflation rather than a typical recession.

C is correct (the EXCEPT answer). Stagflation is NOT a common occurrence; it is a rare economic anomaly. Normal recessions typically feature falling inflation as demand weakens, not rising inflation. Stagflation's rarity is what makes it so challenging for policymakers and investors.

A is accurate: The Phillips Curve suggests inflation and unemployment move inversely, but stagflation shows them moving together (both rising), contradicting this traditional relationship. B is accurate: This policy dilemma is stagflation's defining challenge; tightening policy to reduce inflation increases unemployment, while loosening policy to reduce unemployment increases inflation. D is accurate: The 1970s oil shocks created classic stagflation with double-digit inflation, high unemployment, and stagnant growth, making it the textbook example.

B is correct. Statements 1, 3, and 4 are accurate.

Statement 1 is TRUE: Long-term bonds face a double threat during stagflation. High inflation (8%) erodes the real value of fixed payments, and central banks typically raise interest rates to fight inflation, causing bond prices to fall. This makes long-term bonds one of the worst performers during stagflation.

Statement 2 is FALSE: Growth stocks typically underperform during stagflation, not outperform. Stagnant economic growth hurts all equities, but growth stocks are particularly vulnerable because their valuations depend on strong future earnings growth. Value stocks with stable dividends and pricing power often hold up better, though all stocks struggle during stagflation.

Statement 3 is TRUE: Even though money market yields may rise to 6-7% in response to Fed rate hikes, they still lag the 8% inflation rate, resulting in negative real returns and purchasing power loss. However, cash performs better than long-term bonds because at least the principal adjusts to new higher rates quickly.

Statement 4 is TRUE: Commodities (oil, gold, agricultural products) often rise during stagflation because inflation includes rising commodity prices, and supply constraints (like the 1970s oil embargo) can drive stagflation. This makes commodities one of the few asset classes that can preserve purchasing power during stagflationary periods.