Insight on stagflation

December 1, 2021

Thirteen years ago, just before the Great Financial Crisis (GFC) became virulent, the Google search term “stagflation” was at its highest since the data was gathered. It was a time of strongly rising food and oil prices, while the housing market was starting to display cracks: a recipe emanating from a combination of the terms “stagnation” and “inflation”. Things turned out rather differently, however, with the greatest recession since World War 2 ensuing, and the term “deflation” turning out to the more accurate description.

Google Trends: terms “inflation” & “stagflation”

After a roller-coaster ride in many financial markets in the past nineteen months, and starkly diverging views as to where the global economy is heading, we aim to shed light on the recurring threat of stagflation, its consequences for investors and potential developments. The current situation with all its imponderables in terms of the COVID pandemic and its impact on the economy is an important topic, but so is the governments’ reactions to those covid-related developments.

Stagflation at this point is a threat, not an inevitable outcome. However, we feel that the risk may be being underestimated by many. Since the GFC, there have been numerous warnings of impending inflation by eminent economists and investment strategists. Looking at US inflation measures for the past 13 years, they appear to have been wrong.

US core inflation rate (ex food & energy)

But in 2021, Inflation has surprised to the upside by a wide margin. Will the bout of price rises prove to be transitory, as central bankers everywhere are saying? Or will inflation turn out to be stickier (which we fear for a number of reasons discussed below) and hence eat into consumers’ and corporates’ budgets, leading to lower demand and hence weaker growth for an extended period?

Where next with fiscal stimulus?

One of many complicating factors is government policy. As things stand today, it cannot be said whether another gigantic stimulus package in the US will come – as desperately needed as it may be for the Democratic majority in Congress. The memories of 2010 are still fresh, when Republicans took the House of Representatives from President Obama by a whopping 7 percentage points, resulting in a net gain of 63 seats. The largest swing in 62 years was the result of a number of factors, among them large budget deficits and a weak economy. The prime reason however was the constant bickering between different factions of the ruling party, which in effect forestalled any legislation other than Obamacare.

Betting market odds on midterm elections

With the mid-term elections in November 2022 looming ever closer, the only time to pass meaningful legislation is the coming months, as the midterms will cast their shadows into early 2022, in our view, making any bi-partisan compromise virtually impossible. There is also the question of whether the US debt ceiling will trigger a temporary government shutdown and possible default on Treasuries, something we deem highly unlikely as the Democratic party can pass via a process called reconciliation. Congress’ passing of the infrastructure package of USD 1.2tn, of which 550bn are net new outlays, was a first step in the right direction. It is interesting to note that 6 progressive Democratic House members voted no, while 13 Republican ones supported the legislation. This to us is a sign that the die-hard position of progressives will not take the Democratic party vote hostage and that some form of compromise is possible. The gubernatorial race in Virginia in early November with a Republican winning in a blue state seems to have brought a new sense of realism to the Democratic leadership.

It’s the economy, stupid!

The outlook for the blue side (the Democratic Party) in the midterms, considering betting market odds, is bleak. In our view, its only lever to pull is spending money big, in order for economic conditions to remain favorable until the election, as “it’s the economy, stupid”, to quote former president Clinton adviser James Carville, that decides elections. Whether Congress will be able to pass legislation that will cushion the fiscal cliff, is still open. According to the Congressional Budget Office (CBO), a well-respected bipartisan body that publishes projections on government finances including the expected deficit based on current legislation, the deficit will drop by USD 1.6tn in the fiscal year 2022 which will end in September of next year. Will this be enough to push the economy into recession? We do not think so, as the excess savings on behalf of consumers that added up during the pandemic act as a cushion.

US net private savings (USD bn)

The net effect on economic growth of a shrinking government deficit and a decrease in household saving will likely be negative, if no meaningful new stimulus is passed by Congress. This will lead to dampened demand and hence weaker growth, but will it suffice to cool price pressures too? We are doubtful in this regard.

Inflation is often triggered by a supply shock. While the price spike could fade, it could become the trigger of a wage-price spiral that could drive (goods, services, and labour) price levels up for an extended period of time. This is what we saw in the 1970s. The first oil shock was the proverbial match to light the inflation fevers of that decade, since money supply had already started to surge years before, with the Vietnam War financing costs and the Nixon shock, i.e. the end of the convertibility of the dollar into gold in 1971.


“Inflation is always and everywhere a monetary phenomenon”, the late Milton Friedman once famously said. This notion is fought by a growing number of economists that favor “Modern Money Theory” or “Modern Monetary Theory” (MMT). Put simply, this rather innovative theory posits that business cycles are less the consequence of changes in interest rates (as classical economic theory would suggest), but of changes in tax rates. If an economy overheats, that is if demand outpaces supply, the inflation rate rises. Classical economic theory would suggest this is due to low levels in interest rates, leading to a surge in debt-financed consumption that overwhelms supply and hence leads to price rises. MMT would in a situation suggest to increase taxes in order to reduce demand, so that inflation subsides. “Taxes drive money”, as MMTers say however, meaning that if a surge in inflation takes place (money loses purchasing power), an increase in the level of taxation and hence of government income saps demand and increases “the value” of outstanding government paper (“currency”) at the same time.

Federal Reserve balance sheet size (USD tn)

An important pillar of MMT is that only countries that can print and control their respective currencies get the privilege of employing the “magic money tree”, as some observers call the theory. Proponents can cite empirical findings of the monetary base having grown about fifteenfold since late 2000, taking the Fed’s balance sheet as calculation base. This 14% monetary growth compares to nominal GDP growth of only 4% over the same period.

The solution for many political demands by the political left has arrived: MMT ensures that enough money for fiscal stimulus with the aim of full employment will be provided to “society” by the government, as there are factually no more budget constraints for currency issuers such as in the US. Therefore, one may expect continued acceptance of MMT’s tenets. Critics may argue that with the Fed’s Treasury purchases in the order of a good USD 3tn since March 2020, nothing but debt monetization is already underway in massive proportions. The same holds true for the ECB which added to its government bond positions by EUR 1.5tn during the same period. Looking ahead, we are curious how this process will further develop, as there is ample ground to expect another meaningful injection of central bank liquidity in the next economic downturn.

Global annual inflation rate

The rise in popularity of MMT may be regarded as the reflection of the missing connection between the blowing up of money supply and the absence of any meaningful inflation for years and years. Therefore, inflation is NOT a monetary phenomenon and Friedman was wrong – right?

We take a different position here. The disinflationary environment of the past 30+ years in our view is the result of prudent central bank (and for a long time fiscal) policy which, after the high inflation of the 1970s and early 1980s, was able to put the inflation genie back into the bottle. This may also be seen as the result of the high real (i.e. inflation-adjusted) interest rates that were in place for decades, with an average of a positive 3.5% p.a. (US Treasury 10-year yield minus annualized Core CPI inflation), compared to today’s -3%.

10-year treasury yield minus core inflation rate

Only since about 2010, real 10-year Treasury yields have been been below +1%, while this level used to be the lowest point in the previous decades. The “Quantitative Easing” policies of the Fed, through which the US central bank amassed a significant part of government bonds over the years, was an important driver of this strong fall in real yields. However, inflation rates did not seem to react positively, but rather started to move sideways throughout the 2010s. The reason for the missing transmission of a very loose monetary policy is to be found with two important economic actors: the government itself and the banking sector. The latter underwent a long process of deleveraging as the crisis in 2008/09 had showed that equity cushions in general were too low in the banking sector, so the money multiplier was negative. Second, deep austerity programs, both in Europe (euro crisis) and the US (rise of the tea party), were a drag on the demand side of the economy.

For the coming years, on both sides of the pond, we do not foresee anything remotely similar to these deflationary forces under the name of austerity and sequestration. The Republican party in the US has all but given way to a new economic populism under former president Trump, which completely ignores the negative repercussions stemming from a surge in government debt, as long as taxes are kept at a minimum (deficits by tax cuts). In Europe, with the grand EUR 800bn-heavy post pandemic stimulus package called NextGenerationEU, deficits are more the result of increased government expenditures. The result – high deficits – however is the same. No deflationary impact to be feared from the side of governments, therefore.

Inflation here to stay

The global pandemic, with intermittent standstills of whole economies and societies, did act as a disruptive force in many respects, however we see it more as a catalyst of many changes, rather than their origin or cause. One aspect that had strong inflationary consequences was the disruption of trade thanks to COVID, stemming from harsh lockdowns in exporting countries (e.g. China) halting the flow of goods, port congestions and a dearth of empty shipping containers, to a shortage in essential jobs in delivering goods (truck drivers, warehouse workers).

Google Trends: term “labor shortage”

While many shortages will be overcome over the coming quarters, the core of the issue lies in the short supply of labor. That by itself is the result of many interplaying factors such as an ageing demographic, but also of a long-term downtrend in the share of wages and salaries as a percentage of national income. Put differently, corporate profits have increased their share considerably relative to labor income. One way to look at this change in distribution over time is that the pendulum may have finished swinging to one end, only to turn around and start moving in the other direction. More simply put this means an increase in the bargaining power of labor in the coming years, leading to significant pay raises. From an economic perspective, the view is quite simple: rare supply leads to higher prices. Whether this will give rise to a multi-year wage-price spiral may be questioned, but the recent spike in employment cost indices has clearly shown that the process may have started already.

Corporate profits vs. wages & salaries as % of GDP

Labor supply, where art thou?

Labor force participation may increase in the quarters ahead, due to unemployment insurance having ended for millions of people. What is more, the “social infrastructure legislation”, called Build Back Better program that is currently being negotiated on by US Congress, contains for instance child tax credits and also universal pre-schooling for all three and four year olds, which could have an impact on the participation rate as well. As the package was just approved by the House of Representatives, the Senate will most likely make amendments. It is therefore unclear what exactly, if so, is being passed in the bill.

There appear to be two main developments in the labor market. One is the constant growth of the gig economy (Uber drivers, web developers, pet sitters, …), where the definition of “work” has transformed from the traditional nine-to-five scheme. The other is a tendency to early retire, with even a Wikipedia entry for FIRE (“Financial Independence, Retire Early”). Paired with an ageing demographic, this bodes not too well for the labor force participation rate. Summarizing, the labor shortage will not go away any time soon, in our view.

US unemployed persons vs. open job positions

Wage growth likely to continue

With a new record low in the ratio of the number of unemployed persons to the number of open job positions, another strong argument may be made in favor of continued strong wage growth. While a recession could strongly reduce open job positions, we would deem the chances of economic contraction in the coming quarters as low, therefore the undersupply of labor has come to stay. The job quits rate has reached a record level of 3%, more than 50% above the long-term average. A high job quits rate would speak for rising wages – as leaving a job means taking on a new, likely better paid one. Anecdotal evidence of large employers such as Amazon or the fast-food industry raising salaries at unprecedented levels due to a lack of available labor supply would be another argument in favor of a lift-off in wages.

Some newly formed organization of workers’ interests would add petrol to the fire, of course. However, there appears to be no unionization wave in sight, a factor which could act as an accelerant of the price surge. With communication technology and the spread of social networks evolving at dazzling speed, new developments nonetheless may happen fairly quickly.

Job quits rate and employment cost growth

Weak growth post recovery?

The tailwind that government expenditures provided these past 20 months should not be considered irrelevant. Compared with the fiscal stimulus by the Obama administration in the wake of the Global Financial Crisis, pandemic-related stimulus has to date been a multiple of six or seven. When will government have a net negative effect on growth? Could even a prolonged period of subpar growth be the result of a focus back towards a more balanced budget? MMTers would clearly agree to this latter statement. But what if a sweeping victory by the GOP would relive the ghosts of sequestration? A bleak outlook indeed, not only for the US, but for the global economy as a in such a scenario potentially strong US dollar could act as a wrecking ball among many nations dependent on external funding, financed usually in US dollars. A repeat of the past decade to us however is unlikely, for a number of reasons, primarily demographics (the picture for China looks much more bleak than 10 years ago, while the West is ageing, too), but also a changed world order with a highly self-conscious China challenging, quietly and overtly at the same time, the US as the sole superpower.

But slow growth, paired with a longer period of inflation rates unseen in decades, is a distinct possibility. This would bode well for nominal growth rates and could even be seen by some governments as an elegant way to dispose of a significant part of its debts. The long-term investment conclusions in such a scenario would mean a strong shift away from the winners of the past decade, to a part of the market which has had a dreadful decade in relative terms – the bricks and mortar companies that form the base of an economy and whose products exhibit material marginal costs of production, as opposed to many high-flying New Economy Stocks’ business models. Especially with a view of growing protectionism in some parts of the world, and the threat of a growingly isolationist US, physical production of certain goods will be re-oriented back domestically in many countries that experienced an extreme degree of vulnerability during the sudden stop in the flow of international trade early in the pandemic.


Stagflation, that is sub-par growth paired with above-average inflation, may well be seen as a threat to investors in the medium term. Monetary largesse has accumulated over the past two decades, this is a fact. How the global economy and financial markets will cope with getting weaned off the unprecedented monetary stimulus, will be a perspective that should prove insightful over the coming years. Looking back 150 years of financial history, the monetarist view has explained many cycles of boom and bust quite plausibly. In today’s world of negative interest rates in some countries, some traditional approaches do not work already from a mathematical point of view. Should we see a turn to more MMT-inspired policy measures, the ultimate period of reckoning in the form of a return to positive real rates of interest would only be postponed, we think. We can only hope that the process of deleveraging the balance sheets of central banks can take place in a somewhat orderly fashion, that is over the steady clipping of purchasing power over the years.

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