“[I don’t] really understand where talk of a stagflation scenario is coming from… I don’t see the stag, or the ’flation.”
― Jerome Powell, Chair of the Federal Reserve
So… What is Stagflation?
There are several “-flation” terms that make appearances in the financial press and, unless you took a macroeconomics course in college, you may have only a vague contextual sense of what each means. Specifically, inflation, deflation, disinflation, and stagflation all show up in financial publications, and they are easy to mistake for one another. We all know inflation because of recent history. It’s the increase in prices of goods and services over time which results in loss of purchasing power.
Deflation is the opposite of inflation and is the decrease in prices of goods and services which increases purchasing power. At first glance, having each dollar buy more goods and services seems good for the average person and deflation can indeed be beneficial when it occurs in certain goods such as gasoline. This is because it frees up money for people to use on other things or corrects vastly inflated prices in a particular part of the economy – take used car prices as an example from recent history. Counterintuitively though, broad-based price deflation can be bad for economic growth. Essentially, in an advanced economy with large amounts of circulating debt, price deflation can lead to debt crises in a process known as debt deflation. One example of destructive deflation in recent history is the Global Financial Crisis or Great Recession of 2007-2009 and the collapse of home prices that occurred alongside a mortgage loan crisis. Whether deflation is good or bad for an economy is a topic of some debate in economic circles, but historically deflation has often come as the result of a recession, so deflation has often been more of a consolation prize than a real boon for people. Love it or hate it, many central banks around the world, including the U.S. Federal Reserve, target an inflation rate of 2% rather than zero, partially to have a bit of a buffer against the possibility of deflation. This target has been around since the mid-1980s and, as you can see in the chart below, deflation has been a rare occurrence in the U.S. since the mid-1950s.
Inflation vs. Deflation in the U.S.
Deflation is often confused with disinflation, but they are quite different. With disinflation, prices are still increasing, but the rate at which they are increasing is subsiding. If inflation is the speed at which prices are increasing, then disinflation is deceleration. Just like a car decelerating on the highway from 65 to 55 mph, the car is still moving forward, just at a slower pace. Deflation in this analogy would be putting the car in reverse. Disinflation is what the Federal Reserve wants to see happening in the economy right now. Specifically, they want to stick the “soft landing” in which disinflation occurs and brings the inflation rate down to 2% without slowing economic growth too much or even causing economic contraction. And that, finally, brings us to stagflation.
Stagflation is a portmanteau of stagnation and inflation. Stagnation in the economy means slowing economic growth and increasing unemployment. That coupled with high or accelerating price inflation can be a very nasty combination for reasons you can imagine. Stagflation should be impossible according to classical economic theory. One such theory known as the Phillips Curve asserts that inflation and unemployment have a stable inverse relationship. As unemployment decreases and more people are working, spending tends to increase because of increasing disposable income and that drives inflation and vice versa. It doesn’t make sense that inflation would occur while people are losing jobs and income and, presumably, spending less money. However, the validity of the Phillips Curve has been challenged and is another topic of economic debate. The reality is that stagflation has happened multiple times in the U.S. since the 1970s, a period which exemplifies stagflation in the U.S. For example, 1974 started with the unemployment rate at 5.1% and the inflation rate at 9.39% and both climbed from there while Gross Domestic Product (GDP) turned negative.
Is Stagflation Occurring Right Now?
The three major measures of stagflation are GDP to measure growth, the unemployment rate to measure the employment situation, and inflation as measured by the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE). GDP is a lagging indicator, meaning it only tells what has happened well after it happened. However, we can also look at the several other indicators to get a sense of the state of the economy in between GDP estimate releases. So, let’s dig into some data.
Inflation
The first question is do we have high or rising inflation? We can try to answer that question by looking at CPI, PPI, and consumer inflation expectations. The simple answer is not really, or at least not in a confirmed way. Inflation, as measured by U.S. CPI year-over-year change, peaked in June 2022 at 9.06% and has since fallen to 3.36% as of April data released this week. That’s a far cry from the 9.39% and climbing figure of 1974 and this is what Jerome Powell pointed out in his comments. While it is true that inflation has fallen substantially from recent peaks, it is also true that the rate of disinflation has stalled, and most measures of inflation are not making substantial further progress towards the 2% target. This week, in addition to CPI, we got Producer Price Index (PPI) numbers as well. PPI doesn’t make headlines as often as CPI and PCE, but it measures inflation for producers as opposed to consumers. Typically, if producers are paying higher prices for the components they need to make goods or provide services, we can expect that to flow through to the consumer in short order and have knock-on effects on CPI and/or PCE. The April PPI release was hotter than expected, but March PPI numbers were revised lower and the data under the hood of the April numbers told a softer story than the headline numbers. Because of this the market largely shrugged off PPI data in favor of focusing on CPI this week. Lastly, we received more data on consumer inflation expectations in the last week and those expectations have increased. The University of Michigan Inflation Expectations and NY Fed Inflation Expectations reports both showed consumer expectations of future inflation are rising. Neither of these are major indicators, but inflation expectations are important because sentiment and expectations inform consumer decisions and that ultimately has a real impact on the economy. It’s likely that expectations are up on recent hot inflation reports and they may come down with soft reports like we got this week, but it’s something to keep an eye on.
Ultimately, this latest CPI report reinforces the idea that inflation may be sticky, but it is not clear that it is rebounding to new highs and, current state, that risk doesn’t seem to be of high probability. The other data is similar with inflation for producers bouncing around without moving meaningfully in one direction and consumer expectations around inflation following the data. Nothing is conclusive in the inflation figures and data may continue to languish in a range for a while yet. With inflation now examined, let’s turn our attention to the stagnation piece of stagflation.
Growth
As mentioned before, GDP is our primary indicator of loss of momentum in the economy. U.S. GDP grew 3.4% in the 4th quarter of 2023 which was down from 4.9% in the 3rd quarter. Current estimates of 1st quarter GDP growth for 2024 are 1.6% which is down from the last two readings, but it’s also just an estimate and GDP has been solidly positive since the second half of 2022. We won’t have the final figures for the 1st quarter of this year until the end of June. As you can see, there’s a long lag on GDP information. So, what else might give a sign of how growth is looking currently in the U.S.? There are several factors we can look at including surveys of producers, unemployment reports, and consumption indicators.
US ISM Manufacturing and Services PMI
Starting with producers, the ISM PMI report provides information from the supply side of the economy and is generally watched to indicate in real time if manufacturing and services are accelerating or decelerating. A headline reading above 50 is considered expansionary while a reading below 50 is considered contractionary. If both Manufacturing and Services PMI are below 50 for an extended time that serves as confirmation of a trend of losing steam. The ISM Manufacturing PMI spent all of 2023 in the below-50 range and just broke that streak in March of this year, but it is once again below 50 as of the April report. That by itself doesn’t tell us much since those readings tend to bounce around from month to month and the manufacturing PMI has been on an uptrend for many months. On the services side of the economy, the ISM Services PMI managed to stay above 50 for all of 2023, but recently fell to 49.4 in April. So, with both Services and Manufacturing PMI below 50, is it time to panic? No. Either or both of those numbers could jump back above 50 in May, but it’s something that we are watching.
Employment Data
The employment part of the equation is monitored through the unemployment rate which is released once a month, but initial jobless claims and continuing claims are released weekly and can give a sense of the direction the unemployment rate may go. As of April, the U.S. unemployment rate is 3.9% which is back up to where it was in February of this year and the highest it has been since January 2022 before that. Unemployment is certainly trending up, but it is still historically low. One economic indicator based on the unemployment rate which has received a lot of attention in the last year or two is the Sahm Rule, named after the economist who created it. The rule states if the 3-month moving average of the unemployment rate is 0.5% above its lowest point in the last 12 months, then that may signal initial stages of a recession. However, Caludia Sahm herself has remarked that this rule cannot be relied upon as a sole indicator of recession. Regardless, the current Sahm Rule value is 0.37% so that level has yet to be reached. Although if it is, expect to hear more about it. While we wait for the next unemployment rate release in June, we will continue to receive other employment data such as job openings and initial and continuing claims for unemployment insurance. Job openings have been declining since August signaling that hiring may be slowing. Initial claims for unemployment insurance is the number of people newly applying for unemployment and this number has been higher than expected for the last two weeks. Continuing claims account for people who are already unemployed and are applying to remain on unemployment insurance. This number climbed through the first half of 2023 and has largely leveled off since then. The tight labor market was often blamed during the highest periods of inflation and softening in the labor market has been viewed as a good sign of disinflation. However, too much labor weakness can also be a bad sign for economic growth in the long-term, so we don’t want to see substantial further weakening of the labor market.
The U.S. Consumer
The third aspect of growth we can examine is the health of the U.S. consumer. U.S. economic growth relies heavily on consumers, and we are a society that particularly produces and consumes services. That’s why Manufacturing PMI can spend a year in contraction territory and yet the economy can grow robustly on services demand. So how is the U.S. consumer doing? Retail sales are one indicator of discretionary spending in the economy. Declining retail sales suggest that people are spending less money and that could translate into declining corporate earnings. Retail sales in April had a 0% growth rate, which marks the second month of declining sales growth. While it cannot be said that’s a trend yet, and retail sales growth has been positive for eight of the last 12 months, this is an important factor to watch as further declines could confirm a negative trajectory. Consumer sentiment is another indicator of the health of the U.S. consumer since sentiment informs decisions. People who have a gloomy outlook on the health of the economy are less likely to spend money and may instead favor saving for rainy days ahead. Since the U.S. economy relies on consumption, poor consumer sentiment can be a negative indicator. The preliminary Michigan consumer sentiment survey showed a big drop in sentiment in May, but we’ll need to see if this gets revised up when the final numbers are released later this month. Consumer sentiment has been choppy but trending up since 2022 and the better the consumer sentiment, the more that bodes well for growth.
The Stagflation Scorecard
Let’s review the stagflation scorecard and the three factors being graded. Do we see high or rising inflation, high or rising unemployment, and slowing growth? Inflation has slowed its deceleration, but there is not a clear sign of inflation rebounding in any significant way and it has come a long way from the highs of 2022. The high or rising inflation part of stagflation does not appear to be in place. The unemployment rate continues to climb slowly higher and there are some recent signs of labor market weakness in the form of increasing new and continuing unemployment claims. However, the Sahm Rule recession indicator is still not flashing red, and unemployment is still below historical averages. It’s safe to say that the current state of unemployment isn’t screaming stagflation. Finally, GDP growth is still in positive territory and, although it appears to be slowing, we won’t be able to confirm that until June. Meanwhile, both Manufacturing and Services PMIs are just below 50, which is in contraction territory, but one month is simply too soon to draw a conclusion. The U.S. consumer also might be getting exhausted as shown by recent declines in both retail sales and consumer sentiment, but once again, it is early to draw definitive conclusions from that data. It could be argued that we’re seeing early signs of slowing growth, but that trend could also reverse direction in the months ahead and this is data we continue to monitor. Remember to always take future outlooks, ours included, with a grain of salt. Crystal balls are notoriously murky and new information always has the potential to change the outlook quickly.
Jerome Powell is correct that we don’t have “the stag or the -flation” of the 1970s at the current moment, but we want to look forward as well as assessing our current situation. Slowing growth could be a problem for a stock market which just this week hit fresh all-time highs. Soft data on employment and growth may be good news for the prospect of Fed rate cuts in the short-term, but it’s not good news for the economy in the long run. We want rate cuts without growth rolling over. We want the Fed to cut rates despite robust growth because inflation is under control and that could still be the reality of the situation. I always like to end on a high note, so elsewhere in the world, the Eurozone officially exited a technical recession which is further evidence of growth outside of the U.S. and the European Stoxx 600 index just hit an all-time high this week as well.
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