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Core inflation is currently running almost two percent below its five-year average. quickproduction.sk The latest jobs report from the Bureau of Labor Statistics showed a loss of 23,000 nonfarm payrolls, versus the average five-year monthly gain of 201,000. mic-globe.ca That combination – inflation lower and the jobs market weaker – ought to be a recipe for easier monetary policy, right? Not this time. Despite that dramatic decline in inflation from its generational highs in 2022, both core and headline inflation remain stubbornly above the Fed’s target of two percent. And the shaky trend in nonfarm payrolls notwithstanding, the overall unemployment rate remains relatively benign at 4.1 percent. Prediction markets still accord a 35-ish percent chance of a rate hike when the Federal Open Market Committee meets in the middle of September. ipatineteelectrico.com That’s lower than the rate hike odds immediately after the FOMC’s July meeting, and very strange press conference that followed, but still plenty high, with one jobs report and two inflation readings to come before the September meeting.
Stagflation Yes or No?
At the macro level the biggest concern, and the one we have been trying to get our heads around for the better part of a year, has been the possible return of stagflation after its long hibernation in the wake of the Volcker Fed’s shock therapy of 1979-82. The return of Smoot Hawley-era tariffs last year, the fact of US public debt to GDP at its highest peacetime levels ever and zeroing in on its all time high during the Second World War, and finally the outbreak of war in the Middle East in February of this year all suggested the near-inevitability of stagflation.
According to Phillip Braun, a professor of finance at Northwestern University’s Kellogg School of Management, stagflation is already here. In an opinion piece for this Thursday’s New York Times titled “Stagflation, the Scourge of the 1970s, Is Back” Mr. Phillips cited weakening jobs growth, above-target inflation, higher oil prices and slowing GDP growth (just 1.5 percent, annualized, in the second quarter) as evidence for there being, in his words, “no doubt that stagflation has returned.” The article goes on to warn us about the perils of a politically sensitive Fed in handling the stagflationary threat, drawing a plausible link between former President Nixon’s Fed chief Arthur Burns and the present-day man in that job, Kevin Warsh.
Is it, though? Is there really “no doubt” that stagflation is back? We have long since done away with the notion of ascribing “no doubt” to pretty much anything other than the 1990s-era musical group by that name fronted by Gwen Stefani. Here’s something to think about: in the past year, core inflation has come in hotter than economists’ forecasts in only one month. Tariffs caused the end prices certain categories of goods to rise, but in many months those price gains were offset by lower costs in key services categories (and services, lest we forget, account for a vastly larger percentage of economic growth than manufactured goods). Core inflation, as the above chart shows, is currently running at 2.47 percent while the headline number, knocked around hither and yon by the ever-changing state of play in the Middle East, sits at 3.3 percent. Those aren’t stagflationary numbers. In April 1980, core inflation was 14.6 percent and nonfarm payrolls declined by 145,000. Now that’s stagflation. We’re not there, not yet.
The Stock Market Factor
Here’s another difference between today and the late 1970s: the stock market. Back then, the market was limping through a dismal decade that would only end in August 1982 when a Salomon Brothers economist, Henry Kaufman, pronounced the end of the long bear market in bonds. Today, of course, the stock market is at record highs, both in terms of price levels and valuation metrics like cyclically adjusted price to earnings, which are very close to the nosebleed levels of the late dot-com era.
The stock market factor matters, because the total value of US listed equities currently stands at 238 times total gross domestic product (GDP). A crash in the market of a magnitude similar to that which followed the bursting of the tech bubble in 2000 would most likely have a pronounced effect on the so-called “real economy,” sending conditions of modest growth into decline with a commensurate hit to the labor market. That’s when we could really feel the unwelcome return of stagflation.
The FOMC’s September meeting is shaping up to be one of the more difficult ones in recent memory. A rate hike of 0.25 percent may be the best way forward for the Committee. It won’t thrill the stock market, but it is already enough of a baked-in possibility that it would likely not, by itself, cause major damage. Getting inflation back to two percent would then give the Fed more room to maneuver when the going gets tougher, without the threat of stagflation hanging over its head like the sword of Damocles. There’s no way to get a perfect read on what the macroeconomic numbers are telling us – but choices will have to be made. And we are quite sure that Kevin Warsh does not want his future legacy to be tied to that of Arthur Burns.