Stagflation – the unusual combination of high inflation and slow economic growth – remains unlikely, but the risk rises. The normal business cycle for the American economy is a ping-pong between high growth-with-high inflation and low growth-with-low inflation. The Fed's double-mandate to protect employment and contain inflation guides the use of monetary policy tools to moderate the swings from one extreme to the other. Nevertheless, every so often the economic cycle diverts into stagflation (low growth-with-high inflation), which albeit rare is highly punitive for equity valuations and a policy nightmare for the Fed.
Stagflation can be a short-term problem with limited effects (other than some market over-reaction). Stagflation can be triggered by a mix of conventional trends (such as a moderate economic slowdown) coinciding with an external shock or one-off policy decision (e.g., broad-based import tariffs). In this case, a direct and vigorous policy response from the Fed and Treasury can ensure that the effect of temporary high inflation dissipates before materially affecting the economy's main drivers.
However, stagflation can easily turn into a multi-year issue when it affects the level of corporate investment (a classic emerging market stagflation cycle). At risk of oversimplifying and excluding services for argument's sake, price stability depends on an economy's capacity to supply enough goods (by either manufacturing or importing) to satisfy aggregate demand. To maintain this level of supply, a country has two options: importing, or investing in its domestic production capacity. According to data from the World Bank, the US has maintained a relative stable 20% to 22% ratio of gross fixed capital formation (GFCF) since recovering from the global financial crisis, which has allowed a relative stable-to-slightly higher level of total production. However, were the US's GFCF to drop below app. 20% of GDP it is likely that the country will not be able to maintain the same production capacity thus reducing supply and, by default, triggering a type of inflation that is much tougher to solve.
The Fed would likely fight stagflation with a blunt object - as Volcker did in the 1970s and 1980s. The problem for policy makers combating stagflation is that there is no easy trade off - if they tighten policy (e.g., hiking rates ) they would hurt an already ailing economy. Conversely, if they lower the rates to stimulate the economy they could make a bad inflationary problem worse. Facing this dilemma, the Fed would likely choose to choke the economy to stimmy inflation rather than the other way around, like Volcker did in 1979 (see the chart below, with data from the St Louis Fed). In emerging markets - from Argentina to Turkey and beyond - governments have repeatedly demanded the Central Bank relax policy to stimulate the economy even when inflation is high, and the result is often the same: they get higher inflation and an even deeper recession.
What to monitor? CPI and unemployment first, but in the end everything to do with investment. As a matter of headline risk control, checking on every release of inflation data and unemployment - from PCE to CPI and PPI, and from NFP payroll to initial claims - makes sense as the market, in its nervous state, will likely over-read and over-react to every deviation from consensus. But as a way to analyze the longer-term development of stagflation, the key datapoints are likely to come from investment-related data some of which are going to be embedded in national accounts (like GDP) and others will be disseminated as part of industrial production or ISM data.
