Bad News, I’m Afraid
James Rickards

Most economists don’t believe we could have stagflation today. The prevailing view is that recessions are characterized by higher unemployment and reduced spending, and inflation is triggered by full employment and increased spending and therefore they cannot both happen at the same time.

This prevailing view is wrong, as I explain today. Yet it’s a powerful narrative that blinds most analysts to situations where stagnation and inflation are both happening at the same time.

That’s stagflation and it is emerging today.

The first wing of the stagflation thesis is stagnant growth. This can take the form of an outright recession (two consecutive quarters of declining GDP) or simply slow growth at a rate below the potential growth of a strong economy.

The U.S. economy has grown in recent years, but growth has remained below historical averages.

What growth we have had wasn’t due to monetary policy. It’s been the result of extreme fiscal policy including annual deficits that are now approaching $3 trillion per year. Fiscal policy that involves direct government deficit spending does produce growth that monetary policy cannot. The question is: at what cost?

Basic Keynesian economics holds that government spending at a time of recession or when consumer savings are too high can stimulate growth. If the national debt is moderate, it’s possible to get more than $1.00 of growth for $1.00 of government spending financed by borrowing.

Today, these conditions don’t apply.

The Keynesian Multiplier Is Broken

The national debt-to-GDP ratio is 134%, the highest in U.S. history. Government spending is often directed at non-productive projects such as the Green New Scam and subsidizing illegal immigration.

When debt rises faster than GDP, which it presently is, the debt-to-GDP ratio grows, and the Keynesian multiplier shrinks. You are trying to borrow and spend your way out of a debt crisis, which can only end in default (unnecessary since the U.S. can print dollars) or hyperinflation (likely).

Those extreme outcomes (default or hyperinflation) happen in the endgame, which can be years away. What happens in the meantime is not much better.

Any debt-to-GDP ratio above 90% will produce a Keynesian multiplier of less than 100%. With a debt-to-GDP ratio of 134% the U.S. can only expect more debt and weaker growth from fiscal policy.

This may provide a short-term boost for Biden in an election year, but it’s a long-term drag on growth for the U.S. In the end, the U.S. is now Japan. The Japanese debt-to-GDP ratio is about 300%.

Japan has been in one long depression since 1990 punctuated by nine separate technical recessions. Japan cannot “stimulate” its way to growth. They can only continue deficit spending to prop up nominal growth while making their debt ratio and slow-growth problems worse.

The U.S. (and much of the world) is following the same path. Stagnation in the form of weak growth and occasional recession is the future of the U.S. economy despite recent strong quarters.

The stagflation hypothesis is entirely intact.

Inflation

While the stagnation hypothesis is open to some debate, there is no debate about the persistence of U.S. inflation.

Inflation has been going up for three straight months. In fact, inflation has been in a persistent range centered around 3.3% for 10 months. Inflation is back. In truth, it never went away.

Oil prices are one factor. The price of oil was $68.50 per barrel last Dec. 12. It peaked above $86 in early April and has since pulled back a bit to $78 today. But the trend has been higher.

That oil price surge has not worked its way through the supply chain yet. It’s resulted in some price increases, but more are in the pipeline. It’ll keep inflation at current levels or higher in the months ahead.

The Fed is looking for signs that inflation is coming down but they’re not going to get them.

Other factors driving inflation from the supply side include the Key Bridge collapse in Baltimore, the closing of the Red Sea/Suez Canal shipping route and continued fallout from Ukraine war sanctions. Some of these supply side constraints may be deflationary in the long run but they are definitely inflationary in the short run.

When you add it all up, the inflation hypothesis is strong and getting stronger. Growth is also slowing, as I explained above, so both components of the stagflation thesis are intact.

But the Fed and their Wall Street toadies can’t see that.

Garbage in, Garbage Out

That’s because the Fed forecasting models are junk science. Those models will always get the wrong result. If that’s true (it is), and if Wall Street is following the Fed (they are), then Wall Street will get the forecast wrong also. It’s the blind leading the blind.

We can start with the Phillips curve. This model says that there is an inverse correlation between unemployment and inflation. If unemployment is low, one should expect inflation to be high, and vice versa. The rationale is that tight labor markets lead to wage demands that increase spending and feed inflation.

The problem is there’s no empirical data to support the model.

In the early 1960s, the U.S. had low unemployment and low inflation. As late as 1965, inflation was only 1.6%. In the late 1970s, the U.S. had high unemployment and high inflation. Inflation peaked at 13.5% in 1980. Unemployment that year was 7.8%.

Unemployment peaked at 10.8% in November 1982. Inflation that year was still 6.1%. In the 1930s, the U.S. had high unemployment and low inflation (actually deflation). Unemployment was estimated at about 24% in 1932. Inflation that year was negative 10.3%.

In 1973–1975, the U.S. had low unemployment and high inflation. In October 1973 unemployment was only 4.6%. Inflation that year was 6.2% on its way to 11.1% in 1974.

In other words, the Phillips curve is junk science. There are many causes of both unemployment and inflation, but a strict inverse relationship is not one of them.

The Fed Doesn’t Even Get Interest Rates

The Fed also takes the view that interest rate cuts offer “stimulus” and interest rate hikes offer “monetary tightening.” That’s also false. During times of severe economic distress (the Great Depression is a good example), interest rates drop to near zero.

When economies are booming, interest rates rise because companies are competing for more funds to expand capacity and to make investments. Things can go too far. High rates will eventually lead to overcapacity and recession. Low rates will eventually lead to investment opportunities and a new expansion.

But those turning points happen at the extremes as part of a normal business cycle. In the normal state of affairs, higher rates are associated with good times and low rates are associated with recessions or worse.

The Fed has this exactly backward. The Fed doesn’t lead the business cycle, it chases it.

In short, the Fed is persisting in tight monetary policy in order to fight inflation. But inflation is not caused by the Fed. It’s caused by supply-side disruptions (oil and transportation bottlenecks) and a range of other factors the Fed doesn’t control.

The Fed is tightening into what may quickly become a recession. Yet inflation is rising because of supply chain problems, asset bubbles and rising wages.

This is a recipe for stagflation. It’s coming soon.

 

James G. Rickards is the editor of Strategic Intelligence, the latest newsletter from Agora Financial. He is an American lawyer, economist, and investment banker with 35 years of experience working in capital markets on Wall Street. He was the principal negotiator of the rescue of Long-Term Capital Management L.P. (LTCM) by the U.S Federal Reserve in 1998. His clients include institutional investors and government directorates.

His work is regularly featured in the Financial Times, Evening Standard, New York Times, The Telegraph, and Washington Post, and he is frequently a guest on BBC, RTE Irish National Radio, CNN, NPR, CSPAN, CNBC, Bloomberg, Fox, and The Wall Street Journal. He has contributed as an advisor on capital markets to the U.S. intelligence community, and at the Office of the Secretary of Defense in the Pentagon.

Rickards is the author of The New Case for Gold (April 2016), and three New York Times best sellers, The Death of Money (2014), Currency Wars (2011), The Road to Ruin (2016) from Penguin Random House.

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