Moody's Talks - Inside Economics - Bonus Episode: Deep Dive - Stagflation

Episode Date: August 30, 2022

In this bonus episode Mark, Ryan, and Cris discuss all aspects of stagflation, including the definition, the causes, and what they're watching to assess the risk of this scenario.Follow Mark Zandi @MarkZandi, Ryan Sweet @RealTime_Econ and Cris deRitis @MiddleWayEcon for additional insight. Questions or Comments, please email us at [e-mail]. We would love to hear from you.  To stay informed and follow the insights of Moody's Analytics economists, visit Economic View. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by my two co-hosts, Ryan, Ryan, Sweet. Hi, Ryan. How are you? I'm good. I'm down at the beach, so no complaints. You look like a beach bum.

Yeah, my whole family, we're all beach bums. We could stay on the beach for weeks. How long did you take you to grow that beard? Since vacation started. Yeah. So it's been like a week. The old man in the sea, I must say, though. You look like you've been out pretty weathered there out in the ocean.

They're looking for Marlin or something. Well, I'm chasing my three kids around. It's not really relaxing. My wife and I can't just sit on the beach and take a nap. We ought to chase them and make sure they don't go too far out in the ocean. Yeah, I forgot about those days. Yeah. And that was Chris Therrides.

Chris was chuckling. Hey, Chris. Yes. Hi, Mark. And you're in the office safely. Hi. I am in the office. Any more folks showing up, or is it still pretty sparting there?

Quite, quite sparse. I think we have three people on my floor today. Goodness. Remote work is live and well at Moody's Analytics. So to give you an idea, there's one more person in Westchester on Chris's floor than there are people in Ocean City, New Jersey. So Dante, he's right behind. He's a couple streets behind us.

Oh, you're saying colleagues. Our colleagues, they're all there. Are you ever? Yeah, we're all down in Ocean City. Oh, my gosh. So who's doing the work? Is that, is that me? Chris, Chris and I are doing the work.

They're remote. They are remote. Yeah, I still publish on working. Good point. You're on this podcast. Yeah. Well, this is a special podcast, a little bit different than the others. We're going to focus on a topic.

The topic at hand is stagflation, high inflation and high unemployment. And we'll come back to the definition of that. This has been top of mind here in the US and really all over the world. Inflation is high, most everywhere because of the shocks created by the pandemic and the Russian invasion of Ukraine. And while we've been kind of downplaying the risks that we actually get into a stagflation scenario, we are getting lots and lots of questions from you, dear listeners. And so we thought we kind of do a deeper dive here and talk about. stagflation in a more rigorous way. And that's the purpose of today's conversation. So it's

about stagflation. And the first thing I think we need to do is define it. Define stagflation. That's that's a kind of a slippery concept. Hey guys, should I take a crack at that? Would you be okay with that if I kind of put my sort of straw man definition out there and you can kind of run with it? Is that sound okay? Yeah, sounds good. And go for it. All right, okay. Well, in my mind, there are three necessary and sufficient conditions for stagflation.

First, high inflation. And high inflation, I would say is an inflation underlying inflation rate that is more than a percentage point above the Federal Reserve's target. So let's just use CPI consumer price inflation as our benchmark. I would put the top end of the target, the Fed's target, at about 2.5%. So first condition for stagflation is inflation that is consistently above 3.5%, a full point above the Fed's target range. Second, high unemployment. And here, I would say that would mean an unemployment rate that is more than a percentage

point above our estimate of the unemployment rate consistent with full employment. Right now, I'd put that at about 3.5%. That's current unemployment. Some would put it higher. I think the Fed would put it at 4%. But let's say high unemployment would be anything above 4.5%, you know, probably closer to 5%. in the current context.

So inflation above, CPI inflation above three and a half and unemployment above four and a half, probably closer to five. And then the third criteria would be, you need high unemployment, high inflation for a period of time, not a month or two or not even just for a few months.

It's got to be a while. So I'd say certainly no less than six months, probably closer to, you know, nine, 12 months before I'd say, okay, we're in an environment of persistently high unemployment, persistently high inflation. And that's a definition I would use. I mean, you could kind of combine the high unemployment, high inflation to something called what is historically been called the Misery Index. That's just simply take the inflation rate, add the unemployment rate, and the two of those things are called the Misery Index for obvious reasons. I mean, if you have high inflation, high unemployment, it's a miserable economic

environment to be in. People don't feel very good about how things are going. And if you use that, that would say, by my definition, you'd need a misery index of 2.5% plus 4.5% that would be 7%. That feels low. I mean, I kind of want to say the misery index has to be double digit, it, you know, but you know, not necessarily. I mean, if I told you we were at, you know, three and a half percent inflation and a five percent unemployment rate between now and the end of 20, 23, I don't, that feels like stagnflation to me,

you know, at least some variation of the theme. So that's the definition. So, okay, so the three criteria, persistently high unemployment above the full employment, unemployment rate, persistently high inflation above the Fed's target range, and persistent is the key word here. It's got to be at least six months, probably closer to a year before you call it stackflation. What do you think as a working definition of stackflation?

Chris? Yeah, I think that you hit on all the factors, and I think you also hit on the fact that duration matters a lot, right? It's not just a temporary blip that we're talking about. It's something that is persistent. And that there are shades of gray here, right? It's one thing if, yeah, unemployment or inflation is just over 2% or closer to 3%. Right.

And in addition to that, I would say the trend matters, right? If things are moving along but they're slowly improving, right? That's a different situation than if things are moving the opposite direction. And so I think as a framework, it makes sense. And then the degree to which we worry depends on the specifics about the duration and the trajectory that we're under. And I guess you kind of implicitly made a good point. And as there's no arbiter of how to define this taxation. I mean, we debated, we've been debating recession here for weeks, months.

And there is a, you know, we've all agreed, I think, most of us agreed. We have a final arbiter on recession. that's the business cycle dating committee, the group of academic economists at the National Bureau of Economic Research, but they're not going to sit there and say, oh, this is a stackflation. There's no one out there.

In fact, what about us, Scott? Three of us should be the arbiters. What do you think? That works for me. I like it. Yeah, I like it too. So your misery index right now is at 12. Yeah.

But I wouldn't call this stackflation, right? I wouldn't call it either. Because late 70s, early 80s, and probably the last time we had to act inflation was 22. Yeah, but going back to my definition, it doesn't meet the criteria, right? Because unemployment is 3.5%. That's the full employment unemployment rate. So it's not, we don't have high unemployment.

We're not even close. You need both. You need both. It's not right. And the other thing I'd say is the inflation rate, you know, it is elevated on CPI inflation. It's 8.5% through July year over year. but it feels like it's coming in here pretty fast, right? So that's the other thing.

To Chris's point, the trajectory is, doesn't feel like stackflation. If we continue on this deceleration path that we're on seemingly on right now. I'd say the misery index is a nice rule of thumb, but 1% increase in unemployment matters a whole lot more to consumers, households than 1% in inflation, I would argue. So really? I don't know. That's a great, great question though. Let me ask you that. So 1% unemployment, that means what?

How many people does that represent? 1% of the labor force, the labor force is 150 million. That would be 1.5 million Americans who lost their jobs, right? That's a recession. That's a one percentage point increase in unemployment, who's 1.5 million people unemployed. Yeah. 1% increase in inflation, you know, that what is what is what is what is income? What's nominal income now?

It's I want to say maybe you can look that up. I'm not sure. I'm doing it right now. Okay. You want nominal? Yeah, nominal income, total personal income because I'm going to take 1% of that. And that that's the law. of purchasing power, right?

I mean, that's kind of how I would do it. Yeah. Right. I'm gonna- Is our first order effects, right? I say personal income is $17 million, $17 trillion. I'm just saying. I should get a cowbell if I'm right.

Your way off. 21.7 billion. Trillion. Trillion. Trillion. Yep. Oh, because GDP is like $21 trillion, right? So income is this that really?

That's nominal personal income. Personal income and outweighs. Really is $21 trillion. Is it June? I guess there's one trillion. Okay, anyway. So 21, okay, so 1% of that is $210 billion. Yeah.

That's a cowbell. What's a cowboy? I don't know. One percent of $1 trillion. You got a low bar. You got a low bar. So it's the difference between $1.5 million unemployed America. or a loss of $210 billion in purchasing power for all Americans.

And you're saying the one percentage point on unemployment feels worse than the one percentage point on inflation. Okay. All right. That's an interesting question, though. I'm not sure. Fair enough. Fair enough.

Depends where you're at as well, of course, right? Yeah. Yeah, sure. If you're at 19% inflation and you go to 20, right? Who cares, right? Oh my gosh, don't even want to visualize that possibility. Yeah, but yeah, I hear you. We're going to go global in a moment here, right?

Yeah, true. Good point. Because the stackflation concern is not only here, it's everywhere. And before we go there, so are we all in agreement that, well, first let me ask you, Ryan, anything else you want to add to the definition of stackflation, the kind of the benchmarks I use? used? I think you've hit on all of it. I mean, do you think inflation expectations should be factored in? That goes to the persistency. That goes to the persistency. Okay. So I think that's more a cause of not a not something I would use to define stagflation. But we'll come back to that

because clearly inflation expectations matter a lot in terms of getting to stagflation. Okay. So we're all in agreement. on that. So, and we're all in agreement, the current point in time, we are not experiencing stagnation because unemployment is just too low. We're creating too many jobs on unemployment. The inflation is painfully high, but the labor market is very strong. You would agree with that. Yeah, okay. All right. What about Europe? I mean, there, I guess the same thing at this point in time, Right. Unemployment's still pretty low in most of those countries, even though the recession seems more likely. But inflation is higher now in most of those countries, like the UK. Yeah. I would say some countries are already in stagnation. Like in Estonia with the double digit, what I think 18, 19 percent inflation. And I think unemployment rate probably five, six percent. Hey, Ryan, that deserves a cowboy. You know, Estonia, really? We talked about a couple podcasts ago.

Did we? I'm going off memory. Oh, is that right? Yeah. Anyway, I know it's elevated because of all the exposure to Russian gas that they have. It's very acute there. Right. So, and if you go a little beyond Europe, I get Turkey, certainly.

I think you've classified that as being in stagulation. Right. Actually, I don't know. I know the inflation rate's very high. I didn't realize his unemployment that high as well, well about its full employment unemployment rate? I didn't know that. I believe so.

I believe so. That's a good question. Yeah. Okay. All right. So there are cases small number in small countries, but there are some cases overseas that if they're not in stagnation, they're pretty close, you know, even by our definition. And just if we go across countries, it's important to point out that the full employment

unemployment rate varies a lot. from place to place, right? It's, you know, much higher in much of Europe compared it to the United States. So a 3.5% of unemployment rate in Europe would be well beyond full employment. We did a bloom past full employment. So, but there's differences there. Okay. Let's then ask the question, what are the causes of stackulation? How do, how do economies get into this mess? Of course, in the U.S., the last time we were in a stackflation environment, at least by our definition, that would have been in the 70s, second half of the 70s and the first half of the 1980s. What is all the underlying causes of stackflation? Chris, you want to tell you that? Sure. So I would say broadly speaking,

there are two causes. One is a supply shock, like the oil shocks that we experienced in the 70s, and the second is some type of policy error. And it's probably the combination of those that really enhances or leads to a truly miserable stagnation environment. That's what happened in the 70s in the U.S. We had these supply shocks in Iran oil. And at the same time, we had monetary policy errors in terms of the Fed easing when they should have been tightening. We had price controls on the fiscal side. You had some policies also that were certainly contributing to additional inflation. So wage and price controls, that certainly was a problem. what else happened.

We had the gold standard, right? We transitioned off the gold standard. So depreciation of the dollars, so that transition period also likely contributed to the situation as well. Maybe as one-offs, each one of those might have been handled appropriately, but it really was that combination of all those factors that led to a particularly painful stagnation area environment. Right. So maybe I, maybe you said it, but I'll provide more of a framework around it.

Sure. I think the first thing you said is a supply shock. So that's a hit to the supply side of the economy. And back in the 70s and 80s, that was primarily oil. Yep. OPEC oil embargo, the Iranian revolution. In the current context, that would be the Russian invasion of Ukraine, the higher oil in ag, commodity prices and the pandemic. So there's some similarities there. The second you said is a policy error. And I guess there you're focusing on the Federal Reserve. They didn't see this back in the 70s and 80s. They didn't understand or see because stackflation was not something that we had experienced.

They didn't understand it. And they were trying to figure out how do they respond to this supply show? shock, do I raise interest rates to slow growth to combat the high inflation or do I, do I worry about the high unemployment and I ease lower interest rates to try to help the economy out and bring down unemployment? Two very different policy prescriptions. And obviously, they got it wrong. The speculation wasn't even allowed in the model, right?

Wasn't even allowed in the way. In the original Keynesian models, right? There was no provision for Stact. It wasn't possible under that framework. Yeah, exactly. Yeah, this tradeoff unemployment and inflation. Yeah, you had that very clear Phillips curve, so-called Phillips curve, right? Yeah.

And I guess the one thing that contributed to that mistake was a complete misunderstanding or no understanding or even no thought of this concept of inflation expectations. Yeah, that's right. And Ryan, do you want to explain that what that is and why that's so important? Why inflation expectations are so important? Yeah, and how we think about that now. There's a couple of ways that we kind of look at and measure inflation expectation. You can look at surveys that consumer.

So University of Michigan, for example, ask consumers, what are there expectations for inflation, you know, one year from now, five to ten years from now? And what gets embedded in people's inflation expectations are the prices that they see on a daily basis. So it's gasoline prices, it's food prices. But the Fed also looks at market-based measures, inflation expectations. And I think three of us pay way more attention to market-based measures because that's where the bond investors are putting their money where their mouth is. And why inflation expectations are important is that, you know, it gets embedded in people's behavior, you know, consumers alter the behavior depending on where they think

inflation's headed, you know, in the medium term, and businesses do the same. So that effectively will determine how people behave now. Is there expectations of where prices are headed down the road? Yeah. And I guess in the 70s and 80s, there was not even a kind of a concept of inflation expectation. It was just that was, I guess that concept was born out of that period. If people realize, oh, my gosh, you know, if inflation gets embedded in people's

expectations about future inflation, it's much more likely that inflation will be realized and get kind of embedded and trenched in the economy. And that Phillips so-called Phillips curve, the relationship between, you know, unemployment and inflation shifts. It kind of moves out, you know, because of the shift in inflation expectations. And in the 70s and 80s,

how would you measure market-based measures of... I don't think you could, right? You didn't have tips. You didn't have treasury inflation for Texas securities back then. Right. I guess you could have teased it out of the... You could tease it out of the bond market.

You could do long-term, interest rates, I guess, I think you could. Yeah, you could probably decompose the tenure. Yeah, 10-year treasury yield into the constituent components and kind of back out inflation to the residual. But certainly no one was doing that at the time. No, and it just wouldn't be as clear cut as using tips today. Yeah.

And I guess it's the real-time data, right? Right. Or you'd be making a host of assumptions. Yeah. Right. Right. And I guess the other sort of concept that we now have a pretty good understanding of that was born in that period that's related to high inflation expectations is kind of the wage

price spiral, right? So if workers think inflation is going to be high in the future, they go to their employer and they say, look, my cost of living is rising quickly. I have to pay more to commute into work. I have to pay more for my clothing and to go to work for my, to take care. care of my kids so I can come to work. You, Mr. Mr. and Mrs. employer,

you got to pay me more to compensate for that. And then the business person says, oh, okay, Mr. Mr. and Ms. Worker, I'll pay you more because they think that inflation is going to be high. They can pass along their higher costs

in the form of higher prices. And you get into this kind of self-reinforcing negative wage price, what we call spiral, wage price spiral. And that is all a result of these higher inflation expectations. And once you get into that dynamic, then you get into this kind of high inflation,

unsustainable kind of economic environment where the economy starts falling apart and unemployment starts rising. And you've got this common, bad, very noxious combination of high inflation and high unemployment. Yeah, so Mark, it's getting kind of expensive to drive in. It's getting expensive at the grocery store. Chris and I could use. Yeah, but your inflation expectations are,

Well anchored. Oh, they're anchored. Yeah, they're well anchored. You know they're coming back in. Yeah, I know. Yeah. So that doesn't work with me. That argument.

Here's the third thing, though, I'd say. So, Chris, you said causes. First, supply shock. Second policy error, meaning the- Both monetary and fiscal. Monetary and fiscal. Oh, and on that front, going back to Europe, that feels like that could be an issue, right?

I mean, in terms of monetary policy, both monetary and fiscal policy. Yeah. We were talking about that today earlier. We had a meeting of international economists or international economists, and we're talking about, particularly the U.K., they're thinking about, because they're, you know, Boris Johnson's out and somebody else is coming in, and that, I guess, the leading candidate wants to pass fiscal support to help with the cost of the higher energy cost that they're facing. And that's fiscal, so-called fiscal stimulus, borrowing money to provide this cash to households

to navigate through. But that kind of runs counter to the policy prescription that, you know, you would think you would follow because if inflation is high, you want to get inflation down. But they are kind of juicing the economy with this extra stimulus. You know, it's understandable what they want to do. People are hurting and they don't want them to hurt, particularly low-income households have big energy bills, particularly as a small-income households. particularly as winter approaches and they want to help them.

But the result of that may be it keeps inflation persistently high, exacerbates the inflation expectations. And it feels like the UK has a much greater risk of going into stagflation because of that policy. Would you consider that a policy error then? Yes. Yeah. There's also talk of price controls across the continent as well, right? Oh, really?

I don't know that they're certainly their party. There's a lot of elections going on. you guys in Italy, those guys are probably the Italians that are thinking about. There's always some party in Italy that advocates for any old policy. Did price controls work in the 70s and 80s? They did not. Yeah, I didn't think they worked. Briefly, they and they just exacerbated the problem, right?

Yeah. They work until they don't. Well, here's the third factor I throw in, though, the third cause. This is maybe a big difference between now and then in the 70s, 80s. It's kind of some structural factors or forces. And maybe you mentioned this in the economy that reinforced the wage price dynamic. So, for example, if you go back in the 70s, 80s, the economy was much more manufacturing base, construction based.

It was highly unionized, but more importantly, a lot of the labor contracts had so-called cost of living adjustments, so-called COLAs. So they automatically had workers got automatic increases in their wages when inflation was high. So that that served to reinforce this formation of this wage price spiral, of course, which is at the heart of the statulation scenario. You see that as a consequence of unionization? No, well, not necessarily. I think it was well intention, right?

In the low inflation environment, you're saying, hey, guys, you employer, you just got a compensate from you for inflation plus whatever productivity growth I get so I don't think per se that's a bad thing except if you get into this kind of stackflation environment with a supply shock and then all of a sudden it's a turbocharger on this wage price spiral and you know causes all kinds of problems and so I think as a result of the experience of the 70s and 80s and the monetary policy response that to ring that out a lot of those COLA contracts got broken and you know colos I think are I don't know what share of contracts have those today but I would imagine pretty small how many I mean because one that comes in mind is the federal government

do they have cost of living adjustments in the in those contracts I believe so oh really are you sure yeah no I'm not 100% sure yeah but whenever you know I forget about a month it is you can calculate the coal adjustment and every January the personal income report talks about the cost of living adjustment for federal workers. I don't know if it's everyone. It's just, I can pull up. Well, Social Security. Yeah, there you go.

That's a big one in that Cola. That's definitely the case. Yeah. Every Social Security recipient gets a one-year bump related to last year's inflation rate. So all the Social Security recipients this year are going to get a big increase, right? Because based on the inflation rate as of, I think now, they're going to reset it pretty here pretty soon. I think it's August or something where they,

used that month to figure out what the cost of living adjustment is going to be. But that's a good point. And I guess there are other structural differences, you know, between now and then. Well, we clearly aren't as dependent on oil or energy as an economy. And certainly not as much on foreign oil, right? So, yeah. There's some insulating effect, which maybe. be a reason why we haven't experienced an even worse situation given what's going on in energy

markets. Right. Okay. So supply shock. Yeah. Now considering what's going on now and whether there's the fodder for or the groundwork for stagflation developing in the current environment, certainly supply shock. We got that, right?

I mean. More than one. More than one. Yeah. Yeah. Yeah. Feels even worse than what happened. in the 70s and 80s, right? That was, well, of course, as you say, oil was much more important

back then. So maybe it's the same, roughly the same thing. But we've got the pandemic, disrupting global supply chains and labor markets. That's a massive supply shock, fading, but still, you know, it's playing a big role. And second, the Russian invasion, that's higher oil, natural gas, agricultural metals prices. So two massive shocks to the supply side of the economy. So we got that. I guess the structural different, there are big structural differences, right? We, it doesn't feel like we're in the same kind of league. So that would suggest stackplation would be less likely now than in the 70s and 80s.

And that gets to the policy response. Here's, I suspect, is the big difference between now and that, right? Right. And Ryan, so do you want to talk about that? I mean, what is the appropriate policy response to an environment where stackflation might become, you know, more of an issue? Well, I thought you laid it out well earlier in that the Fed really doesn't have a playbook for stackflation. Stacflation. Central banks in general don't have playbooks for stackplation because it's their worst nightmare because how do they respond? Do they raise interest rates to slow the economy down to bring inflation back down closer to their target?

but if they do that, then unemployment continues to rise. Or vice versa, do they cut interest rates to stimulate the economy to reduce unemployment, but then that would juice inflation higher. So the Fed's response in the 70s and 80s was just jack up interest rates as quickly as possible, as aggressively as possible to wring out inflation. But that wasn't, you know, that pushed us into a recession. So there's no, you know, playbook for that. And that's why, you know, later on we talk about.

stackflation odds in the U.S., they're low because the Fed's facing Hobson's choice, either push the economy into a recession to avoid stacculation or risk the economy eventually falling into a period of staculation. I guess in the 70s and 80s, the policy response was first in error. Because here's the thing, we probably should have said earlier, the stack, the high inflation that developed in the late 70s and early 80s actually started all way back in the 60s, right? Yeah.

Because we had, and in that, the 60s inflation coming into the 70s was, felt more like it was demand driven, right? You had a Vietnam War, you had the great society, you had a lot of government spending, expanding fiscal deficits and debt, and it pushed the economy, past full employment, and wage and price pressure started to develop. Then you got into the 70s, and I think in 1973, you know, you had the first oil embargoes. ago and that caused oil prices to go skyward and we were much more dependent on oil back then.

Then another round of spikes in 1980, the Fed didn't really understand the dynamics here. It was more focused on the impact of the of the shocks on the on growth and high unemployment accommodated with easier policy trying to keep the economy moving and keep unemployment down. But that just exacerbated the inflation and the it got to a place so that by 1979, 1980, when Paul Volcker finally became Fed share, we had, I think back then, 15% consumer price inflation and unemployment was, you know, headed towards double digits. I mean, you know, we closed in at 10% on the worst of it in the early 80s. And there was a massive change in policy, monetary policy at that point in time where Paul Volcker said, no, this is, this is,

this is all wrong. We got to ring out the inflation is our number one problem. We got to ring that out. And so I'm going to jack up interest rates, meaning we're going to have a dozy of a recession and we did to wring out those inflation expectations and bring inflation back in. And once we get inflation back in, then we can start worrying about the unemployment and trying to get to the other side of the recession. So it wasn't a mistake. And then Paul Volcker really brought the hammer down. And wasn't the Fed less independent pre-Vulker? I think that's fair to say. Because you remember reading all those reports and stories about the president trying to influence what the Fed was doing.

Yeah. I think that's a great point. And then Volker came in. Yeah. So, so the policy, you know, we say policy error, but it was, but, you know, it doesn't go entirely to the Fed, right? It goes to the fact the Fed was not independent or completely independent from the executive branch. The president, well, you know, had influence. over that. Certainly, I think Richard Nixon used his influence aggressively to try to keep

interest rates down and obviously that exacerbated things. I think it was an inconsistency of the policy as well, right? That was a lesson learned. First they tighten, then they loosen. It was just very confusing for businesses and consumers to understand what the policy was. And Volcker, made very clear, inflation's job one. This is what we're going to do. There was no ambiguity around it. I think that was also helpful in setting those expectations, getting us back on course. Yeah, that's a good point. Good point.

Throughout the 70s, central banks couldn't quite figure what, do I worry about the unemployment? Do I worry about the inflation? They kept swinging back and forth, and you didn't, you got both high inflation and high unemployment. Nothing worked out. Right. Bulker said, no, we're not doing any of that. I'm worried about inflation. I'm letting the economy go where it needs to go to get inflation back down.

Yeah. And interestingly enough, it took a while to get inflation expectations all the way back down to something the Fed would feel comfortable. I mean, Paul Volcker, I think he was chair of the Fed from 1979 to 1987, I think. And Greenspan followed in 1987. And he continued to, he didn't follow a similar policy. You know, he called it a policy of opportunistic disinflation, right where you know he didn't push the economy into recession like wolker did but he said if the economy goes into recession i'm not going to get it out very fast because i want to keep the unemployment rate high and make sure i ring out that wage price spiral in those inflation expectations and it finally probably wasn't until you know when well into the 2000s you know towards the end of

Greenspan's term that inflation finally came back, settled in to where the Fed wanted them, you know, their target. I guess that's the other thing that point out back in the 70s and 80s, there was no inflation target, right? There was no explicit inflation target. No one said 2% is the number, right? It wasn't clear. No.

No, it wasn't until recently that they actually put into paper. Yeah, I mean, recent meaning in the last couple of decades. Yeah, last couple decades, yeah. Yeah, right. So I guess that's the other. There was no policy statement either. So markets just had to infer what the Fed was doing by what was going on in markets. Yeah, you won't believe this.

But when I first started, the Fed never announced what even the federal funds rate target was. You had to figure that out by looking in the market saying, where is it trading? So they wouldn't announce anything. You had to, you know, it was completely opaque, you know, what they were doing. It wasn't until 1994 that they released their first statement, I think. Is that right? Yeah, that was 1994. Yeah, it sounds right.

Yeah, under Greenspan. Okay, so the thinking about the cause is then that gets to policy. So we've got the shocks, the supply shocks. Obviously, we've got that, the high inflation. We don't have the same problem structurally. I think we're in a better place there. But it really boils down to policy. and we learn from the policy mistakes of the 70s

that it probably makes more sense for the Fed to, if inflation is high, ring out the inflation first, make sure that that's back at their target, inflation and inflation expectations are back to their target, and then you worry about the economy and where the economy is. And so that's kind of sort of where we are right now, right? And that means, what that effectively means,

is the Fed is going to push us into recession sooner rather than they're not going to wait if inflation remains high and accommodate it. They're going to fight it and wring it out. If that means recession, so be it. Get inflation back down. And then once you get inflation back down, then you start worrying about getting unemployment back down. And that's what the Fed has basically been saying.

That's what they're communicating is that we're going until we didn't push back. Right. I mean, literally they're telling you what they're telling you what they're saying. going to do. You know, you go look at the, the forecast, they're saying, yeah, we're raising the funds rate three and a half to four percent, you know, in the next few meetings. We're going to ring this out. We're going to ring out this inflation. Yep. Right. Okay. And again, that also goes back to Europe and some questions about whether the European Central Bank is going to be similarly predisposed to do that. I mean, because the Europeans, before all of

had much lower inflation and much lower interest rates. I mean, they had up until a week or two ago, three weeks ago, they had negative interest rates. So, you know, they're obviously now raising rates aggressively, but they're still incredibly low. And it seems more likely that they would make a mistake, that they would be slower to raise rates to wring out that inflation and ensure we don't get into a stack inflation scenario.

What about on the fiscal policy side? What would be a mistake there at this point? Student loan forgiveness. Yeah. Okay, so the president announced that today, the student loan program. But there's a lot of cross currents in that, right? Yeah. Yeah, I don't know that that has any bearing on growth or inflation.

I mean, on the one, you know, you have the debt forgiveness, all the else being equal, that would juice growth and inflation. but then you also have the resumption of the more of the payments. There was a moratorium on student loan payments during the pandemic. That is not going to come to an end. That would be a restraint on growth in inflation. Well, maybe, really? You think? Oh, they extended it again, right?

Oh, yeah. It was to say. Yeah, yeah, right. Good point. But don't you think at this point? Well, I've been wrong before. Yeah. Right.

Right. Good point. Good point. If they don't, then you're right. It would be to cross purposes of the Fed. But if you let the moratorium expire and payments begin, then you do the arithmetic. It kind of washes out any impact on growth or inflation that you have on the debt forgiveness. The magnitude is questionable, right? I think that's really depends on the details. Yeah. All right. If things are extended out longer, how exactly the debt is forgiven. So. Yeah, good point. I think you're right.

I think, yeah, you're right. Yes, there will be an impact, how big of an impact really depends on the, you know, how this thing gets rolled out. Yeah. But I guess you would, I mean, more broadly, you'd say anything, any deficit finance fiscal support or stimulus would probably be a mistake, right, in the current environment. Yeah. Yeah.

I mean, it feels like everything, any proposals now being looked, no matter what it is, is being looked at through the prism. of what does it mean for inflation, like the Inflation Reduction Act, although that doesn't significantly impact inflation in your term. And obviously, everything was looked at through that prism, you know, is it going to significantly and in that case it was not deficit financed. It was paid for, or more than paid for. Everything except tax cuts, right?

Everything except tax cuts? I don't think there would be much interest or discussion around the, at least from one side of the aisle. if we propose tax cuts at this point in terms of inflationary consequence. Okay. Really? Yeah. You guys are so cynical.

Little cynical. My gosh, you guys are really cynical. You're so cynical. It's over my head. It takes me a while to catch up to it. Jeez, Louise. I guess I suppose you're right, though. I suppose you're right.

Okay. So what are we concluding here? Then less likely, we're much less likely we're going to have a stack inflation scenario. here. In the U.S. In the U.S. Okay. Well, a severe statulation scenario, right? Under your definition, if it's just 1% increase in inflation, 1% increase in unemployment, I don't know if that's certainly not very remote.

Yeah. Right. Yeah. It's not way out there on the tail of possible outcomes. Yeah. The 70s style stagnation scenario, which I think is what most people have in mind. I think that is pretty far out on the tail, given the Fed's resolve. but yeah well that was that was like high single digit double digit unemployment and double digit

inflation that feels like that way out that's yeah right okay because we used to go back to our rule of them using the misery index it's at 12 now that's what it was in 2011 and I don't think anyone would argue that we had stagnation in 2011 no say that again the misery index is currently at the same level it was in 2011 oh and oh I see No one was talking about stagulation in 2011. Right. Because inflation was on the floor at that time. Exactly.

Yeah, right. Okay. And that goes back to my point. It's got to be high inflation, high unemployment. Yeah, correct. Okay. All right, so what indicators should we be looking at to gauge whether we're going down the stack inflation path?

What would you look at to gauge if that scenario is coming to fruition? I'd say the expectations are number one, right? Are they getting unanchored or are they coming in as a precursor of where things might be headed and how consumers and investors will change their behavior, right? And they're anchored. Are they? Market-based measures of inflation expectations. Have you looked at five-year, five-year-forwards? Well, have you looked at one-year-five-year-fifference?

You're cherry-picking. Not cherry-ficking. Actually, I was going to ask you, what is your number one favorite measure of inflation expectations? five year forward five five five five year forward uh i mean that would be probably up top for the long run right for the long run and then that's that's inflation five years from now in the subsequent five year period so that's way out there in the future right yeah and i forget which region and that one that one is anchored right i think that is i think Ryan's right no one thinks it's always been anchored though yeah and everyone came close to being unanchored right okay one one

way or another, we're going to get back here. Get inflation. Yeah. Yeah. Well, they're saying like us, there's no such, we're not going to have stackflation. That's not happening. Correct. Not to that magnitude. Yeah.

Right. Okay. So what is your favorite measure? Ryan? Five year, five, year fours. Oh, it is. Okay. All right.

I forget what regional Fed does it. They adjust five year fours for like the liquidity premium. So it's a real measure of inflation expectation. So that's my number one. All right. Okay, that's anchored. You're right. Chris, what's yours? I keep an eye on the five-year break-even just because it's readily available. And explain what that is.

So that's the difference between yield on a nominal five-year treasury and a Tips five-year treasury, so inflation-protected. Okay, and what's that security right now? I don't know what it is right now. It's about to look it up. Yeah, quickly. Last I had looked, it was, it certainly had come in, but it was on the high side, right? It was not, yeah. 2.77. Okay, so that's high.

That is high. It was three and a half during earlier this year. It's come down. At the start of the invasion, right? It should be no more than, ideally, right? You want it two and a half, no more. Right. So we're 20.

We're spinning distance. Yeah, okay, fine. Fair enough. Fair enough. Three and a half, I would be concerned. Oh, here's the other thing that gives me some solace on that, though, Chris. It's five years, right? So you know inflation in the first year is going to be high, right?

Sure. So actually it might actually be two and a half, right? So let's say in the first year, it's high by five percentage points. It's seven and a half percent in the first year, you know, divide by five, right? It's coming in. No, less than it. If it's five percentage points over, divide by five, that's even less than that. it's even less than that.

What am I saying? You know, if it's, if it's, I know, no cowbell for me. Okay. If it's 100,

if it's 1.25 percentage points high in the first year, right? And you divide by five, that's 25 basis points per annum, isn't it? Right. So that's very, so they,

that may actually be consistent with two and a half percent. Mm-hmm. To my point, one year, five-year forwards, right? One year, five-year forward is one year from now. So forget about the next year because we know that by definition that's going to be high.

And it's the five-year period after that. And that is last I looked on the high side. If you look at the ICE measure, the International Continent Exchange, they put together a measure based on break-evens and also on inflation swaps, another way the bond market votes on inflation. And yesterday that was a 2.8%. That made me a little nervous. I mean, I mean, if you look at the inflation swap curve, so what's inflation, you know, expectations over various time horizons, it's, for the most part, they're saying we're going to get inflation back in the next couple years down to 2%.

Okay, fine. All right. In fact, can you, I haven't looked at that swap curve. Can you just send me the link to something I can look at? Or is that off of my computer. I can send it to me. I can send it to me. On Monday. Yeah. Yeah, yeah. When you get back from your bum beach vacation? Okay, you got it. Anything, what other measures?

So it's only, we're looking at inflation expectations. I totally get that. Right now, we're debating it, but it feels sort of okay, you know, maybe on a little bit on the high side, but within, as Ryan said, spitting distance of where we want it to be, so no big deal. What about wage gross? You think we should be focused on wage growth? I mean, I think in the current context, probably, right?

Yeah, the employment cost index. That's growing pretty quickly. Yeah. What's the EC, you want to describe the ECI? I know we haven't passed podcasts. Yeah, the employment cost index is a measure of nominal wages in the U.S. But unlike average hour earnings and other measures of wages, they can adjust for composition changes.

So, you know, average hour earnings gets skewed because, you know, a lot of job growth in leisure hospitality, lower-paying industries, that's going to bias average hour earnings one way and vice versa. But the employment cost index adjusts for that. So that's why I think it's one of the best measures of wages, along with the Atlanta Fed wage tracker because they kind of do a similar thing. The ECI does. And they're both over 5% year over year.

Correct. Right. And by my calculation, what we'd want to see something closer to 3.5%. Yeah. And so one thing I'm tracking like when that kind of leads the ECI by a couple of months is the quits rate. So when you have a very high quit rate, you know, job switchers, they're typically getting higher pay increases and that's going to juice wage growth. So the quit rate is still very, very high. So it doesn't look like nominal wage growth is going to moderate the next, you know, quarter until.

Oh, is that right? That's interesting. That's how I forecast the ECI is one of the inputs is the quits rate. Is it show any kind of leveling off in growth, or is it going to show continue? Yeah, so it was a little bit of leveling off, and then I expect the quits rate to come in, you know, over the next year or so. Right, right. And I said three and a half percent, just for context, that would be 2% inflation plus 1.5% productivity growth. So that's 3.5%.

If you're 3.5% workers are getting their share of the economic pie. and, you know, that would be consistent with stable 2% inflation and we're at 5%. So I think really we should watch that, that ECI, the employment cost index, the land of wage tracker. Hopefully we level off around 5 and start to come in. And the quit rate is a good third indicator, if that's a good leading indicator, as you say, is a good leading indicator of wage growth, which sounds very intuitive. I hadn't looked at that, but that sounds interesting. What about the beverage fare?

So the beverage is the relationship between job openings and the unemployment rate. So where we are, like right now, we have very high job opening rate and a very low unemployment rate. And that's what the Fed wants is to bring that job opening rate down, but without nudging the unemployment rate higher. Yeah. How many of those openings do you think are real? Yeah, right. That's a whole other podcast. Yeah.

Right. Important one. Yeah, I mean, we've got 10 million plus job openings for context before the pandemic when the labor market was really tight. I think it was 7, 7.5 million. So we're at 10. The peak was 11 million plus, so we're coming down, but we're still very elevated. And that doesn't give you a lot of confidence that wage growth is going to start to moderate here, get back to that 3.5%. Except for what you just alluded to, and that is, do you really believe it's a hard 10%?

and 10 million job openings. Like I would suspect companies once they put up a job posting are going to be pretty reluctant to take it down. What they do is they just slowboat any hiring. You say, okay, let's keep the interview process going, sort of tell the candidate to come in a month from now. We'll kind of take our time and maybe we'll offer them something next year on the other side of whatever's happening now, you know, that kind of.

So I, you know, I think there's, we've got to come up with a term. I think there's, I call them soft openings, you know, as opposed to hard job openings. That was the case a few months ago. But there's no way of, is there any good way of gauging that? I don't think so. I can't think of a good way. How real are those job openings? Right.

Yeah, exactly. Okay. But that's, that's a good one, though. We probably should watch that too. So the Joltz survey, job opening Liberty Turnover survey, which has the job openings data, the quits rate layoffs that would be right to watch okay um Chris's favorite jobless claims and jobless claims yeah window into layoffs which again don't show any real meaningful erosion at least not yet uh okay uh what about i say this was some intrepidation productivity growth

i mean obviously as i said three and a half percent is the bogey that assumes one and a half percent productivity growth. We certainly, if you believe the data, aren't getting that now, right? I mean, productivity is declining, at least over the last year. Should we pay any attention to that, or is that just the measurement issues that are just too much to really use that measure in the near term? It's a bit of a lack of measure. I was just going to say I'm skeptical because productivity is volatile, very volatile from quarter to quarter, even year to year. So if we're trying to assess stack inflation risk in the near term in the next 12, 18 months, I've put productivity pretty low on my list.

Right. Okay. Yeah, I kind of agree with you. I mean, if it was a more accurate measure of reality, maybe, but don't feel like it. Okay. Any other indicators you would kind of point to that might be helpful here? Any, Ryan, anything in the financial markets that, you know, think would be useful? I mean, of course, oil prices, like different commodity prices.

Going back to the shocks. Yeah. Yeah, that's a great point, though. You're right. I mean, a lot depends on what's happening with these supply shocks, right? Correct. Yeah. If oil prices are rising, that means much more likely stackflation will become a problem.

If the oil prices are falling or down, not so much or less so. And that's encouraging. And then getting back to another one of Chris's causes, you could look at that. that, you know, the market implied path of the Fed funds rate. Yeah. So if that starts to really deviate from what the Fed's saying, then, you know, I mean, right now they're anticipating the Fed cutting rates in late 2020, so basically they're saying the Fed's going to tame inflation and realize it did too much

and then start normalizing and returning the Fed funds rate to its equilibrium rate. Yeah. Okay. All right. Well, let's wrap this up then, like we typically do. so that we make this more concrete. Let me ask you this. What do you think the odds are of a stagflation scenario developing over the next 12 to 18 months?

And when I say that kind of a minimum viable stagflation scenario, you know, by my definition, one percentage, unemployment being a percentage point above full employment, at least four and a half, probably closer to five. Inflation, one point above the Fed's target on CPI, so let's say three and a half, maybe closer to four, and that we have this in a persistent way. You know, it's not, it feels like it's going to remain in place for, you know, throughout most of this period through 2023, the next 12 to 18 months. That's the stagflation scenario that I would say would be the minimum kind of criteria for being labeled a stackflation scenario. So what's the probability of that happening over the next 12 to 18 months. Chris, you want to go first?

Sure. So for the U.S., we're talking about here. And then we can do Europe or UK. Next, yeah. I would say 10%. 10. For minimum viable. That's not that high. It's not that high. For me, I view the distribution as a bit more barbelled, if you will. Either the Fed is going to be really aggressive and just will go right into recession, right? Bring inflation down with it as an option or or not. We'll escape by. I don't know that we would have the conditions for a stagnation scenario building up, right? The Fed kind of easing back and indecisive. I just don't put a lot of probability weight on that scenario rising. Yeah. Okay. And Ryan, what's what probability would you put on that scenario.

Yeah, I would be close to Chris, 10, 15%, because I think the Fed's going to kill inflation. Right. But by the way, can I ask in that scenario, do we ultimately end up in recession? Yes. Yes. Yeah. Okay. Is that another feature of stackflation scenario that you ultimately end up in recession?

Probably, right? Yeah. Yeah. I've always thought of it as recession plus, right? Oh, is it, well, you're saying you have to be in recession to get unemployment up that high? Not necessarily. Oh, you think? Well, okay, then it goes back to the gray zone, right?

Yeah, interesting. Stagflationary. Yeah. Yeah, if I go up by a point on unemployment, that feels like a recession. Right. Remember, there's never been a recession when an unemployment goes up by 30, 40 basis points on a three-month moving average basis. So you get one point, even if you spread it out over several months, that's a recession.

Yeah. Yeah. I guess in a stagflation scenario, the recession just happens later rather than sooner, right? to allow the inflation to develop and become more persistent. Right. So it's not your typical recession, if there's such a thing. In the current context, that would be you're going to recession fast. The Fed pushes us in fast.

They bring out the inflation. Whereas stagflation scenarios, they don't do that. And we kind of hang in this tough world of recession, but still very high inflation for a while. And then the Fed says, enough already. Yep. you know, I got to ring this out and they push us into recession. It just happens later. Okay.

What are your odds? About the same. Yeah. I wouldn't argue. I might even put it a little lower. You said 10, Chris said 10 to 15. I'd say 5 to 10, you know, something like that. I think the probabilities are pretty low.

So the fact that we all agree on something means we're going to have stack for you. No, I know. That's never good. Well, the only reason I get to 5 to 10 is only to the point you made that the supply shot could reverse it could get worse again right yeah I mean who's to say the pandemic doesn't come back around right or who's to say someone doesn't have an oil happen in oil markets or in the refinery industry that causes oil or gas prices to go skyward again you know so given that there is some meaningful

you know five say five to ten is meaningful but I don't think I think the odds of a mistake a policy mistake they're pretty close to nil I just don't see that happening yeah I mean the Fed is on the war path here, right? Anytime inflation expectations look like they're coming on tethered, they're going to step on their brakes. You mean a policy mistake to cause stagflation? You can still have a policy mistake.

Yeah, policy makes to cause it. I mean, this goes back to the causes of stagflation, right? It's the supply shock, it's the policy error, and it's the structural issues. I'm saying I can't see it. The structural issues are much less relevant unless there's something I'm missing. I just don't see it. I mean, there are structural forces that might result in higher rates of inflation than we're anticipating, like the backtracking on globalization, for example.

That's, you know, maybe global, the increase in globalization in the last decade really weighed on inflation. Now we're backtracking for lots of obvious reasons. Right. So maybe there are some structural things that I'm discounting, but I tend to think they're small. the thing that gets me to 5 to 10% is the shock, you know, that the shock can come back around. It's not on the policy side. I think, I think. But anyway, all right.

What do you think for Europe or Japan? Oh, yeah, great point. Well, can we make a distinction between the U.K. and the rest of Europe, the Eurozone? I think they do. I think they do. I think they do. I say, okay. What's that?

I think they do. Oh, yeah, they do. Yeah, can we do that, please? Yeah, exactly. Okay, what do you say on the UK and then on the Eurozone? This is to Chris. Substantially higher. I'm trying to think where I would go.

I put it higher in the UK probably than the Eurozone. Yeah. And pretty high. Over 20. They're all at 30, 40%. Oh, wow. That is high. Because I do think that they're much more vulnerable to the shocks.

Another shock. Okay. You two, Ryan? Yeah. 30 to 40? 30 to 40. Yeah, no, I'm not that high. I'm closer to 20.

Maybe 25 if you press me. And then on the Eurozone... But you came in at 10 until you heard the 30, right? Yeah. No, no, no, no. I wasn't at 10. I might have gone up from 15 to 20. I don't know.

Subconscious. All about anchoring. Yeah, that's on anchoring. You're pulling me northward. On the Eurozone. I say that that's higher than the U.S. but lower than U.K. So in my, I'd say 10 to 15. So, you know, 5 to 10 for the U.S., 10 to 15 for the Eurozone, say 20 percentage-ish for the UK, something like that.

Yeah. All right. What about like a Japan? I've heard people trying to figure that one out, right? That's. But Japan has inflation? What does that even mean, right? It's tough to.

Well, they're targeted too, and they just barely got. above two with all of this mess they yeah I think they're like two one no I'm not not worried three two four yeah I think it's still this deflation worry not a stack right um okay uh anything else on this topic uh that we think is important that we missed I think we cover a lot of ground I think we feel I feel pretty good about it okay um any uh last call anything else on stack place All right, very good. I think we're going to call this a podcast.

And, listener, if we did miss something, I just have this nagging feeling that there's something we missed that was big, but I can't think what it is. Let us know. And we'll come back around and address that. So with that, thank you very much. And we'll talk to you soon. Take care now. Oh, by the way, this is what I forgot to say.

We run these scenarios across different countries all over the world. world, U.S., UK, Europe, not just the baseline scenario where everything kind of works out, not just a typical recession where we suffer kind of a downturn consistent with the average recession since World War II. But we also run stagnation scenarios. So if you're interested, let us know and we can help you with that. So now, for real, thank you for listening in. Talk to you next week.