Rising Risk of Stagflation

Key Points:

  • Trillions of dollars of deficit spending financed by money creation over the past two years caused today’s soaring inflation.

  • Our enormous government debt may constrain the Fed from raising interest rates by enough to tame inflation.

  • Equity markets are beginning to price the rising risk of stagflation.

  • Investors are repositioning portfolios to protect the real value of their financial capital.

To offset the economic consequences of the pandemic, the Treasury worked hand in glove with the Fed over the past couple of years to transfer trillions of newly created dollars into bank accounts of individuals and corporations. As I wrote two years ago, this policy was “a necessary humanitarian effort to keep our economy functioning through this COVID crisis. By propping up aggregate demand, we aim to prevent a larger than necessary decline in economic output. Failing to do so would risk a depression and profound human suffering.” I went on to warn that “…many more dollars will be chasing a smaller amount of goods and services. The result will be inflation.” Now, the inflation rate that consumers experience, CPI, is galloping above 8%. The inflation measure that the Fed believes it can control, core PCE, is expanding at a rate above 5%.

The bond market is pricing a swift return to low and stable inflation. Investors ought to beware of the risk of interpreting this implicit forecast from bond prices as an unbiased estimate of the future path for interest and inflation rates. The past few decades of low and stable inflation have taught a couple of generations of bond traders not to fight the Fed. When the Fed publishes a dot plot displaying its forecast of future rates, bond traders follow the Fed’s lead, even though these publicly communicated dot plots have been notoriously inaccurate at turning points.

Recognize that inflation expectations can become a self-fulfilling prophesy. Expectations of higher inflation cause people to ask for higher wages and set product prices higher, feeding future inflation. Hence, the Fed understandably seeks to manage such expectations. In so doing, they risk credibility. For example, they almost comically retired the word “transitory” in November 2021 after their failed effort to “talk down” inflation.

The Fed waited too long to tighten and now needs to act aggressively. Capital markets have panicked as investors try to anticipate how soon the Fed will be able to reduce inflation back to target; the amount of tightening of financial conditions and the magnitude of the rise in real interest rates that will be required; and whether this tightening will cause a recession.