Is Stagflation a Risk for the U.S. Economy and How Would Markets React?

Stagflation is a dirty word in a central bank’s handbook. Given recent U.S. economic growth concerns while inflation remains sticky, it is a good time to take a closer look at stagflation and what it might mean for the markets.

What is stagflation?

Stagflation is characterized by slow economic growth, high level of unemployment, and elevated inflation taking place at the same time.

This is a rare combination as a weaker economy with high unemployment generally results in downward pressure on inflation.

The Nightmare Scenario

Stagflation would be a nightmare scenario for a central bank as its policy choices run a risk on both sides.
• When inflation is rising due to a strong economy it calls for a more restrictive monetary policy (i.r. higher interest rates).
• When inflation is depressed by a weaker economy it gives a central bank leeway to cut interest rates.
• What policy does a central bank follow when it faces a slow but growing economy and sticky inflation? If it cuts rates it risks fueling inflation. If it hikes rates to break the back of inflation it risks sending the economy into a tailspin.

But is the status quo an option?

This is the dilemma the Fed would face if the economy slows (see Are There Clouds Looming Over the US Economy? ) but inflation remains above target. Couple that with the Trump administration policies (tariffs, tax cuts) that run the risk of keeping prices elevated.

If this sounds complicated, how do you think Fed officials feel?

The jury is still out on stagflation

I am not saying the U.S. is headed for stagflation but it is a risk that needs to be monitored. So far, bond markets seem to be focused more on recent weaker data that have sent yields tumbling as a stagflation scenario, while a risk, is not the mainstream outlook. For this to become a theme, the job market would need to crack, growth remain slow while inflation and inflation expectations stay elevated.

How would markets react to stagflation?

Markets hate uncertainty and a bout of stagflation would only raise it along with increased volatility.
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The following are typical ways different markets tend tio react::

Stock Markets: Bearish
Stagflation would weigh on corporate profits and therefore likely weigh on stocks in general although different sectors would perform differently. .

Bond Market; Mixed and torn
Much would depend on how a central bank responds to signs of stagflation.
Does it raise rates?
Does it cut rates?
Does it stay pat and try to ride it out viewing the situation as temporary?
What is certain is that volatility would increase around economic data releases. .

Commodities: Bullish for safe havens
Let’s limit the focus to what would be considered a safe haven, such as gold, which would typically be a beneficiary of the uncertainty caused by stagflation.

Currency Markets; Bearish/Bullish
• Currencies affected by stagflation would be weaker vs the dollar or other (safe haven) currencies or both.
• Currencies acting as safe havens would firm vs, the dollar or affected currencies or both.

In any case, the overall mood in markets would be risk off with investors taking a defensive stance until the stagflation situation is resolved.

Is stagflation really a risk?

As noted, stagflation is not the mainstream scenario but one that bears watching. In this regard, keep in mind how markets would typically react should it become a reality. Remember, markets tend to initially factor in the worst case outcome and reassess later on.

Is Stagflation a Risk for the U.S. Economy and How Would Markets React?