The biggest difference between a normal recession and stagflation is the reaction of the Fed. Stagflation combined high unemployment with high inflation – which forces the Fed to us heavy and blunt policy weapons. The American economy is nowhere near stagflation yet, but the direction isn’t good.
Normally, the Fed manages the tug-of-war cycle between inflation and unemployment – when one goes up, the other goes down. Its entire toolbox is calibrated to that cycle; in case of high inflation and low unemployment the Fed can: (a) hike the Fed rate to increase short-term rates; (b) make long-term yields rise by selling long-term debt instruments (quantitative tightening, QT); or, (c) adjusting restrictions on the financial sector to reduce consumer credit availability. Naturally, when inflation is low and unemployment high, the Fed can relax its policy by cutting rates, buying long-term debt (quantitative easing, QE), and loosening financial sector regulations.
Regardless of which combination of tools the Fed uses, the policy goal is to fix the variable that is weak by taking a bit off to top from the variable that is healthy. For example, when inflation is high and unemployment is low (aka an overheated economy) the Fed tightens policy to contain inflation while adding a bit of unemployment to the economy (the same applies to low inflation and high unemployment, but with a relaxation of policy).
But stagflation doesn’t allow that trade-off because both inflation and unemployment are high at the same time. Stagflation is often seen in emerging markets (from Brazil to Turkey and beyond), and it usually follows a period of depressed investment. When investment drops for a sustained period, economies are not be capable of producing enough goods to cover aggregate demand, which triggers inflation spikes. Also, due to the drop in investment and unsatisfied consumer demand, GDP drops, corporates reduce payroll, and unemployment rises.
If – big if – the American economy was to fall into stagflation, the Fed is likely to prioritize the fight on inflation with a severe policy tightening, sacrificing the speed of economic recovery. With the set of policy tools available to the Fed, the natural action in stagflation would be to fight inflation first. With normalized inflation, the Fed can go back to the standard push/pull between unemployment and inflation, cut rates and allow the private sector to pull the economy out of the hole. This is what Paul Volcker did between 1979 and 1983 when the Fed hiked rates to 20% creating a recession between 1979 and 1982 (technically, two recessions separated by a year – in 1H1980 GDP dropped 9% and another 11% between 4Q1981 and 1Q1982) with unemployment peaking at 10.8% by the end of 1982 but cutting inflation from 13.5% in 1980 to 3.2% in 1983.
Importantly, there is a relatively strong chance of a technical stagflation but much smaller of a systemic one. The economy is adjusting to new trade policy uncertainties and a rapid reduction in the government’s footprint thus it is likely that upcoming statistics on consumption and investment will be negative - and possibly into stagflation territory. Similarly, a more protectionist tilt in the administration’s trade policies are likely to fuel a spike in inflation. This doesn’t mean that the economy is jumping into long-term stagflationary conditions but a simple reflection of one-off decisions and transitions. However, were this uncertain environment linger, it is possible that investment decisions would be postponed or even cancelled, which would be the way the short-term technical-stagflation seeps into a longer-term, systemic one.
