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Thoughts on Stagflation

By Simon Tryzna, CFA, Chief Investment Officer

One of the topics I’ve heard creep up in my research reports is the idea that the U.S. economy could be headed into a stagflationary environment in the coming months. While we don’t think that’s the likely outcome, it still is a known risk, and I wanted to write a quick primer on what it is and how it could play out.

In short, economic stagflation is when economic growth stagnates, but inflation persists. While this is an incredibly small sample size (and partly why we don’t think stagflation is likely to occur), this is how it looks like in data readings:

We can see that inflationary data is going up, while economic data shows a slowdown in growth. Once again – an incredibly small sample size, but enough to catch the attention of some investors, myself included.

For this to happen, two things would need to occur: inflation needs to be persistent, and the economic growth slows down. There were many worries in late spring about inflation running rampant, with two camps of thought. The first is that inflation is here to stay, while the second is that most inflation appears to be transitory in nature, fueled by the supply/demand imbalance left as a byproduct of the COVID-19 Pandemic. While inflationary numbers & expectations have crept up, most investment professionals I’ve spoken to believe that the growth in inflation numbers will slow down. The question is – when?

Over the last few weeks, there has been a growing chorus of corporate executives and Fed/Treasury officials that are now warning that elevated inflation will be here through year-end. While that’s not “long term,” many of these same officials thought higher inflation would last only for a few months. Now, inflation appears to be much more sticky than previously anticipated. This is due to a combination of ongoing supply chain disruptions (which aren’t ending anytime soon), continued massive Federal spending, higher savings rates, and Quantitative Easing (QE) by Central Banks worldwide.

Suppose we continue to see higher inflationary numbers. In that case, Central Banks will be under growing pressure to taper, which they will first do by slowing down bond purchases and reversing QE policies. Simply put, QE provides fuel for the economy to grow. Should central banks begin to taper and cut the amount of fuel they are providing, that could lead to slower economic growth.

This could become problematic should economic growth slow down on its own accord, primarily due to concerns around the Delta variant. The University of Michigan Consumer Confidence Index (referenced in the table above) suffered its largest drop since April 2020 (the on-set of the pandemic) and shockingly fell to the lowest level since 2011, dropping to 70.2 from the 81.3 reading in July.   That drop reflects the negative influence of the COVID headlines and reminds us that there is a real risk that the economic recovery does slow meaningfully due to the Delta variant.

While this scenario remains highly unlikely, it does showcase the challenge that Federal Reserve officials have on their hands. That is why every word of theirs has been highly dissected and scrutinized this summer and why it will continue to be that way as we head into the fall months.