Tag: stagflation

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I’ve known since before the inauguration that the economy was facing stagflation. The tax cuts would boost the deficit, raising interest rates. The tariffs would boost prices, producing inflation. Both those things, plus forcing out immigrants, would tank the economy, producing stagnation (at best), yielding stagflation.

I wrote about this more than a year ago, in Our new upcoming stagflation. We are now seeing it, even before the war started.

I’m actually a little surprised we didn’t see it sooner. I credit the delay to a few things. First, Biden had left the economy in really good shape. It took a lot to tank it. Second, even though it seemed to us that Trump was “moving fast and braking things,” it’s just hard to move that fast on things like tax cuts, imposing tariffs, and deporting migrants—even if you’re willing to break laws to do it faster, these things take time. Third, Trump always chickens out, so we didn’t get the threatened tariffs on schedule; we got watered down tariffs after a delay.

However, the stagflation is here. Check out this graph of Real GDP. As you can see, in Q4 it had fallen almost to zero. The economy wasn’t shrinking, but it was stagnating.

A graph of Real Domestic Product with the last data point showing a growth rate of barely above zero.

At the same time, inflation had quit coming down. Here’s a graph of Core PCE, the Fed’s preferred inflation index. After getting down almost to 2% (the Fed’s target) about 8 months ago, it reversed course and has been bumping along close to 3% since then.

A graph of Core PCE with the last data point only a little below 3%

I think all of these things were about to get worse. Even with the Supreme Court’s ruling that a major part of Trump’s tariffs were illegal, there were plenty of others that aren’t going away. The tax cuts are still in place. Immigration has virtually come to a halt, many immigrants have been detained or deported, and any sensible foreigners with skills that they can apply elsewhere are fleeing the country.

So: Stagflation was already here. But things are about to get much, much worse, because now there’s a war on.

That has already spiked up oil prices. Those won’t feed immediately into Core PCE (which excludes food and energy prices), but will feed in over time, because higher energy prices make everything we produce more expensive. And, of course, wars are fantastically expensive, meaning that the deficit will blow out way worse than it was already going to, which will lead to higher interest rates (soon) and higher taxes (later).

Oh, and don’t expect AI to save us. If you listen to the business news, you know that the only reason the economy isn’t in much worse shape is that businesses have been paying huge amounts on AI infrastructure. As I wrote in my AI bubble post, I think a large fraction of the data centers and model training that that money got paid for will turn out to be worth much less than was paid for it.

So, where are we? Well, about where I thought we’d be, as far as the economy goes—in a modest stagflation that could be fixed pretty quickly, at the cost of a substantial recession, if the Fed had the guts for that. Except that now we’re in a war too.

I can tell you how to arrange your finances to survive a stagflationary period, but I can’t tell you have to survive a war. Wars are very bad, much worse than recessions.

If you know how to survive a war, let me know. If not, good luck.

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Many politicians and financial analyst types are suggesting that the Fed should “look through” tariff-induced price hikes. Superficially this makes sense, because a one-time cost increase is not the same thing as inflation. Unfortunately, we know that the results are bad.

The example I’m thinking of is the price shock from much higher oil prices due to the 1973 OPEC oil embargo. As that price shock moved through the economy, first oil prices went up, then gasoline prices went up, but very shortly all prices moved up, because every business faced higher energy costs, and needed to pass at least a fraction of them forward. And then, of course, all the businesses that bought things from those businesses needed to raise their prices further, and workers started demanding higher wages because their costs were going up.

The Federal Reserve tried to “look through” that price shock, not raising interest rates, even though prices were rising. As I say, this makes sense. The one-time price shock will move through the economy, raising many prices by various amounts (depending on how much the inputs for each particular item increase in cost, and the market constraints on price increases for each particular item). Once that all works through the economy, the prices increases should stop.

In fact, raising interest rates could easily make things worse, because the cost of credit is another cost to nearly all businesses, so it’s just another expense that they have to pass on, and it’s a cost to employees, that they’ll want to recover in wage negotiations.

But we know what happened: Inflation rose enough that the Fed eventually decided that it needed to raise interest rates. Higher interest rates hurt the economy, threatening to produce a recession. The Fed cut interest rates to head off the threatened recession, which led to inflation, which led to the Fed raising rates again, etc.

The result was the stagflation of the 1970s, which only ended when new Fed chairman Paul Volker raised rates high enough to produce a severe recession, and then kept them high for long enough to wring the inflation out of the economy.

To me it’s clear that “looking through” the “one-time” price shock of higher tariffs will produce the same result. The Fed can probably mitigate it by holding rates at their current levels until the price shock works its way through the economy (which will probably take a least a year, because many prices (wages, rents, etc.) are only renegotiated annually), and only cut rates after price increases settle back down to close to the Fed’s 2% target.

I assume the Fed governors know this. Do they have the courage to take the right action? Only time will tell.

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A group of friends and I agreed last week that the most likely result of the most likely policies coming out of this administration is stagflation.

Plaque for the Northern Trust Company

Talking about it reminded me of the Wise Bread post I wrote All about stagflation, so I re-read that. I think has held up pretty well, even though circumstances (financial crisis followed by a pandemic) meant that things didn’t play out as I’d expected. Even so, I think the analysis of how to produce a stagflation is right on: raise interest rates to bring down inflation, but then panic when it’s clear that you’re in danger of producing a recession and cut rates before you’ve gotten inflation under control; repeat until you have high inflation and a recession.

That is, stagflation is usually the result of a timid Fed, that’s afraid to do its job.

The thing is, the policies that I see coming (tariffs and tax cuts) will produce stagflation even if the Fed does a great job. The tariffs directly raise prices, and the tax cuts (through increased deficits) raise interest rates, producing a recession.

In the Wise Bread article I warn that it’s tough to position your investments for stagflation. The reason is that inflation makes the money worth less (helping people with debts, but hurting people with money), while the recession hurts people with debts and people with investments.

Upon reflection though, I don’t think it’s quite that bad. In fact, it’s really just regular good financial advice:

  1. Avoid debt (you’ll get crushed by a recession faster than you’ll get rescued by inflation).
  2. To the extent that you have assets, move them into cash (initially you’ll get screwed by inflation, but pretty soon rising interest rates will save you).
  3. Limit your investments in stocks, and especially limit your investments in your own business (both much too likely to get crushed by recession).

Basically: live within your means and stay liquid.