Stagflation or Runaway Inflation? The US Economy Is Experiencing Something New - Barron's

You can't have stagflation if there's no stagnation, and right now the U.S. economy is still expanding, writes Gregory Daco of Oxford Economics.

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About the author: Gregory Daco is the chief U.S. economist at Oxford Economics and former board director at the National Association of Business Economics.

It’s not runaway inflation, and it’s certainly not stagflation. In fact, what the U.S. economy is going through is a severe case of “M.E.S.S.I.” inflation dynamics: Moderating Expansion with Sticky Supply-driven Inflation.   

The U.S. is experiencing a rare phenomenon where strong, but cooling, demand is met by constrained, but accelerating, supply leading to transitory, yet sticky, inflation. These dynamics aren’t purely a reflection of supply constraints; nor are they only an indication of strong demand. Rather, they’re a combination of these two forces creating a messy inflation situation. I wrote about it in an Oxford Economics report earlier this month.

In the debate about whether inflation is transitory or runaway, the truth likely lies somewhere in the middle: Inflation is likely to be sticky but not oppressive. But with successive shocks destabilizing global supply chains and labor supply still tight, many worry about a 70s-style burst of stagflation, fearing that we’re headed for an economy with rampant inflation and feeble activity. 

Clearly, inflation is currently running much hotter than in the decade pre-Covid. But what’s missing in the discussion on stagflation is the “stag” part: stagnation. In the last episode of stagflation from late 1973 through 1975, headline CPI inflation averaged 11% but real GDP contracted 3.1%. Today, headline CPI inflation is running at 5.4%, but real GDP is expanding at a strong 4% clip.

Today, we’re not entering an “inflationary psychology” realm, in which elevated inflation leads households to pull their purchases forward, thereby feeding the demand-supply imbalance and spurring higher inflation. In fact, a recent Morning Consult survey shows that more than half of U.S. consumers decided against purchasing an item in September because it was more expensive than expected. 

A recent Fed paper by Jeremy Rudd also poured cold water on the idea that inflation expectations are central in determining actual inflation outcomes. Rudd convincingly argues that there’s little evidence to show that consumers or businesses act in anticipation of higher inflation, especially in a low inflation regime—when inflation is not on people’s radars.

Recent CPI data confirms these healthy inflation dynamics, with significant pullbacks in prices for categories of goods and services that were shunned by consumers in August and September. With spending on used vehicles falling, and demand for travel and leisure still constrained by the surge in delta infections, prices for used vehicles, rental cars, hotels, and airfare all fell sharply.

Still, a key risk for the inflation outlook is the possibility of a feedback loop between wage growth and consumer price inflation. During previous high-inflation regimes, this cycle tended to be strong. But after the economy entered a low-inflation regime in the 1990s, the dynamic dissipated.

Sure, there’s abundant evidence of strong wage growth at the lower end of the income spectrum, while small businesses are reporting record levels of wage increases and record-high wage expectations. But it doesn’t appear workers have permanently gained more bargaining power. 

Instead, the current wage dynamics likely reflect a one-time re-levelling of low wages amid lingering labor-supply constraints. Wage measures adjusted for compositional shifts in the labor force—such as the Atlanta Fed wage growth tracker, or the Employment Cost Index—don’t point to spiralling wage inflation. And, if anything, consumer-confidence readings have shown a deterioration in inflation-adjusted income expectations, with only 30% of households expecting to be better off financially in a year. This is the lowest level since August 2016. 

What’s more, with productivity growth accelerating since the onset of the pandemic, unit labor-cost growth has fallen to a meager 0.2% year over year – compared with growth of 1.7% from 2015 to 2019. As such, businesses should be able to manage higher compensation costs without excessive pressure on their margins and thus the need to pass on higher costs will be low.

Of course, the combined impact of elevated resource utilization, lingering supply constraints, and higher commodities prices is an upside risk to any inflation forecast. But, given the negative fiscal impulse in 2022, the gradual rebound in domestic and global production, and the expected gradual tightening of monetary policy, the risk doesn’t appear extreme. 

Overall, many factors that led to inflation-regime shifts in the 1940s and 1970s, including a politicization of the Fed, price controls, massive currency devaluations, and oil price shocks, aren’t present today. Instead, structural factors, including higher savings and lower spending as the U.S. population ages, ongoing technological advances, solid productivity growth post-pandemic, and sustained (though slower) globalization, should keep a structural lid on price pressures.

In this context, much of the criticism of the Federal Reserve’s accommodative monetary policy stance appears misguided. While the Federal Open Market Committee has had to repeatedly revise its inflation forecast up and admit that higher inflation is likely to persist, the Federal Reserve has sent out strong signals that the quantitative-easing asset purchase program will be phased out by mid-2022 and that rate liftoff will occur by late 2022 or early 2023. 

Yes, it’s naïve to think that the Fed can unclog ports, boost semiconductors production, or free labor supply. But more hawkish monetary-policy guidance and a gradual tightening of the Federal Reserve’s policy stance will lead to a tightening of financial conditions via higher long-term rates, a stronger dollar, and potentially lower stock prices. This should help limit the pace of demand growth and thereby constrain one of the prime inflation drivers as supply gradually ramps up.

Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to ideas@barrons.com.

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