Stagflation now, as deflation risks grow

Even the world's largest economy can have a bad day!


Here is the short answer:

We are in stagflation now. This is elevated inflation with slowing growth. It is highly likely a deflationary period will follow, and some degree of recession will be recorded in 2024.

There are some economic conditions becoming easier, like a lower US dollar and lower oil prices, but the tightening by the FED is now sparking a credit crunch with continual banking issues. A credit crunch will result in loan contraction, demand destruction, and eventual significant job layoffs. This will likely be the basis for a US recession call by the NBER in 2024.

Can a recession be avoided? Sure, if the credit crunch is addressed and short term rates and the US dollar are lower.

Recessions are periods of deflation. The FED knows a deflationary period while debt to GDP percentages are high (120%) is extremely dangerous to the financial system. The FED will have to take measures to limit deflationary risks to avoid a depression. Of course, the US Congress may reduce spending over time to address the debt issue, but in the short term, the FED is the only fire truck available.

The US 2s10s yield curve has a very good track record of forecasting recessions (deflationary periods) in the next 18 months, currently, it is forecasting a recession early in 2024. This suggests unemployment is expected to rise in 2023-H2. The pace of higher unemployment will determine how long stagflation lasts and how quickly deflation appears.

Reflation, deflation, stagflation, inflation, goldilocks chart.

Chart explained.

Green line = US unemployment rate YOY% (US growth measure)
Purple line = US PCE less food and energy YOY% (US core inflation measure)
Red line = (green line * -1) + purple line (growth and inflation measure)

Note: Red line is mostly dominated by the green line, until the purple line hits extreme levels.

Falling red line = Falling growth and disinflation (red line above zero) and or deflation (red line below zero).
Rising red line = Rising growth and reflation (red line below zero) and or inflation (red line above zero).

Goldilocks is when the red line is rising or above zero while the green line is falling and the purple line is also falling (or depressed). This is clear evidence of growth expanding while core inflation is mild.

Reflation is when the red line is rising from a low base while the green line is falling and the purple line is rising. This is clear evidence of growth expanding and core inflation recovering.

Stagflation is when the red line is above zero while the green line is rising and the purple line is also rising (or elevated). This is clear evidence of growth rolling over while core inflation is high.

Deflation is when the red line is below zero while the green line is rising and the purple line is falling. This is clear evidence of a sharp fall growth and inflation. Deflation can also be highlighted by falling stock prices (black line) and US NBER official recession periods. However, US NBER recession periods are declared months after the event.

The US Fed's primary concerns are employment and inflation. Deflation must be avoided at all costs while debt levels are high. The red line is of primary concern to the FED. Changes in the red line directly affect the FED's monetary policy.


Better than your local economist!

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