Inflation + Recession = Stagflation

What is “stagflation”? It’s when prices for goods and services are increasing while the economy is not growing. Are we headed towards it?

Well, by any measure, inflation is a problem. For example, take a look at the consumer price index (CPI) going back to the early ‘70s:

Sources: U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items in U.S. City Average [CPIAUCSL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPIAUCSL, August 26, 2022.

U.S. Bureau of Labor Statistics, Consumer Price Index for All Urban Consumers: All Items Less Food and Energy in U.S. City Average [CPILFESL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPILFESL, August 26, 2022.

As chair Powell stated on Friday, August 26, 2022¹: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” 

Looking at inflation as measured by CPI as seen above (for other inflation measures go to the GFMI article The Long and Short: Inflation + Recession = Stagflation), there is a lot of work to do.

Powell further went on to state:

“Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”

I don’t think there is any doubt about the future of short-term rates. But the key question to consider is what will happen to long-term rates? Will the markets perceive the Fed is doing enough to bring down inflation? Or, will it be the opposite?

In my opinion, if the Fed does not tackle the inflation issue, the global markets will lose confidence in the Fed. This will have catastrophic consequences for the economy, U.S. dollar, and the U.S.’s ability to raise funds.

So far, the good news is the Sahm Recession Indicator is not indicating an immediate recession. On the other hand, some of the other indicators appear to pointing to recession down the road. A lot will rest with the U.S. consumer and their reaction to higher interest rates. Only time will tell.

Bottom line: It looks like a strong probability we are heading into a period of stagflation or, given the Fed’s resolve on inflation, it seems like an outright recession is also a possibility.

If you’d like to learn more about these economic indicators, let us know. GFMI offers a number of Economics and Capital Markets courses for both new and more experienced capital markets participants.

 

¹See Chair Powell’s Speech “Monetary Policy and Price Stability” August 26, 2022 https://www.federalreserve.gov/newsevents/speech/powell20220826a.htm