A Recipe for Disaster: Stagflation
Have you ever followed a baking recipe to the T, or at least you thought you did, but the cookies were hard instead of chewy, or the cake fell flat? Mix the cookie dough too much, and you get tough cookies. Use old baking soda instead of baking powder, and your cake will crater.
The reality is one misstep in baking will often have a disastrous impact on the end-product.
The same holds true for the economy. The master baker, aka the Federal Reserve, has followed the central bankers’ main recipe for supporting the economy when faced with a significant adverse event. The recipe calls for cutting every interest rate within their reach and supporting the price of bonds with massive purchases in the bond market. To shore up the U.S. economy amidst the global COVID-19 pandemic, the Fed started a $120 billion per month bond-buying program in mid-March 2020.
The Fed’s buying certainly aided in the U.S. economic recovery when everything was being shut down and continues to help the healing. U.S. GDP expanded at an incredible 33.4% pace in the third quarter of 2020 after declining more than 30% in the second quarter. Full-year 2020 GDP still dipped 3.5%, which was much better than economists’ initial forecasts for a 6.5% drop.
The recovery continued into 2021, with 6.3% GDP growth in the first quarter and 6.5% in the second quarter. The Conference Board now anticipates 7% GDP growth in the third quarter, and it expects the U.S. economy to expand at a 6% annual pace for 2021 overall.[1]
With a robust economic recovery underway, many economists call for the Fed to start tapering its bond-buying program. At the annual Kansas City Federal Reserve conference, Fed Chairman Jerome Powell hinted that the Fed could reduce its buying in the bond market later this year. Still, in the same breath, he defended the Fed’s easy monetary policy.
I think it’s essential everyone understand that the Fed is currently walking a tightrope. Politically, there will be tremendous pressure on the Fed to keep its current policies in place. It’s widely understood that if interest rates start rising, it’ll likely slow the economy and hurt the stock prices. However, there is a cost to be paid if the Fed continues too long. To continue to buy large batches of bonds could create another, possibly more significant, issue in the U.S. economy. In the words of Aesop, “It is possible to have too much of a good thing.” (Unless we’re talking about chocolate chips in cookies. You can never have too many chocolate chips!)
Specifically, it appears that the Fed is risking pushing the economy into a period of stagflation. You only need three ingredients for stagflation—slow economic growth, high unemployment, and inflation—and all three are in the mix right now, which has ignited growing concerns about stagflation in 2022.
Slowing Economic Growth
As we just discussed, the U.S. economy has recovered quickly from the global pandemic and is on track for about 6% annual GDP growth this year. However, U.S. economic growth is expected to slow down dramatically in 2022.
Goldman Sachs recently stated that it anticipates the U.S. economy will only grow between 1.5% and 2% in the final six months of 2022.[2] The International Monetary Fund (IMF) expects U.S. GDP growth of 7% in 2021 and only 4.9% in 2022.[3] And the Conference Board is forecasting 4% GDP growth in 2022.[4]
High Unemployment
At the start of the pandemic here in the U.S., nearly 30 million employees lost their jobs in two months. The recovery in the jobs market has been slower than the overall economy’s rebound. The Labor Department recently reported that 943,000 jobs were added in July, the most considerable increase in nearly a year. The unemployment rate also dipped to 5.4%, down from 5.9% in June.
However, even with these impressive numbers, we’re still a far cry from the 3.5% unemployment rate before the start of the pandemic. The fact is that there are still about six million jobs missing since the onset of the pandemic—and 1.7 million of these jobs are from the hospitality industry, which is still struggling to find its feet.[5]
Rising Inflation
The exponential rise in inflation took the Fed by surprise this year, as our central bank was anticipating that the Personal Consumption Expenditures (PCE) price index would climb 2.4% in 2021, and only 2.2% excluding food and energy prices. The latest PCE data showed that inflation soared 4.2% year-over-year in July, and core inflation rose 3.6% year-over-year.[6] Inflation is well above the Fed’s 2% target level.
The Consumer Price Index (CPI), which measures the price we pay for goods and services, climbed 5.4% year-over-year in July. Core CPI has risen 4.3% in the past year.[7] The Producer Price Index (PPI) has surged 7.8% in the past 12 months, or the biggest jump in more than a decade.[8]
There’s no doubt that inflation is alive and well right now. The question is, will it be transitory as the Fed claims?
Overall, we’re in an environment that could bake up stagflation: slowing economic growth, rising inflation, and high unemployment.
Yet, the Fed continues to flood the economy with money. By its action, it remains more focused on job growth than on taming inflation. Severe supply constraints throughout the economy further exasperate inflationary conditions; the price of virtually everything is going up. With millions of Americans still out of work, it’s growing easier to see that stagflation could become a genuine problem in 2022.
If you’re concerned about the current inflationary environment and the growing threat of stagflation, I encourage you to reach out to us at Nicollet Investment Management today. We can help you develop a long-term financial plan to protect your wealth from the risks of stagflation.