Stagflation Ahead?  

Summary 

• The 2021-22 oil price shock is an outlier: it led to a spike in core inflation but not a recession. 
• This reflects a recovery in workers’ bargaining power together with belated and limited policy tightening. 

• Stagflation would be a risk if the Federal Reserve (Fed) got serious about returning inflation to target as it would require a recession, which would take time to lower inflation. 
• This is unlikely anytime soon as inflation is not contentious enough yet for the Fed to find the political will to tip the economy into recession. 

Market Implications 

• I expect the strong growth and high but stable inflation macro backdrop to continue and provide the basis for stock and bond market stabilizations. 

Missing Oil Shock Recession of 2021-22 

In this note, I discuss stagflation risks currently facing the US economy. I argue that they come more from inflation inertia than from higher oil prices. 

Oil prices are up 30% since mid-year and there is a good chance that they could remain above $90 for an extended period of time (China Growth Tracker – Picking Up!).   

Up to the early 1990s, energy price shocks have been associated with stagflation (Chart 1). By contrast, since then energy price spikes have had little impact on core inflation or growth.   

This partly reflects the lower energy intensity of the US economy relative to the 1970s (Chart 2).   

However, this is not the whole story: the 2021-22 oil price spike raised core inflation above 5.5%, the level of the late 1980s, though it did not prevent a strong recovery.     

Other factors at work include workers’ bargaining power, the inflation regime, and the policy mix. 

Workers No Longer Willing to Absorb the Energy Tax 

Higher energy prices can be seen as a tax on the US economy since a greater share of sales must be dedicated to paying energy bills, meaning less is available to share between profit and labour income. How ‘energy tax’ gets split between profit and labour depends on the relative market powers of employers and workers. 

Until the early 1990s, the adjustment to higher energy prices happened against a backdrop of stable or rising labour income share (Chart 3). By contrast, from the mid-1990s, labour’s income share fell due to factors such as globalization, labour-saving technological innovation, and pro-employer labour market policies. These reduced workers’ bargaining power.    

With stronger worker bargaining power in the 1970s and 1980s, the oil shock could not be absorbed through slower wage growth and instead caused inflation. 

By contrast, with weak worker bargaining power since the 1990s, energy price spikes have been absorbed through wages increasing by less than productivity (Chart 4). The mid-1990s is when the gap between worker productivity and real wages started widening. This caused slower growth in unit labour costs and structurally low inflation.    

By the late 2010s, however, labour’s income share recovered. This reflected both strong GDP growth and long-term factors such as immigration restrictions. Workers’ bargaining power further increased during the COVID-19 pandemic due to labour shortages. In this context, firms struggled to get workers to absorb the 2021-22 ‘energy tax’, and wages and prices soared. 

High Inflation Regime Causes Strong Passthrough  

Another factor driving the impact of energy prices on inflation and growth is the inflation regime. As the BIS explains, the dynamics of inflation are very different based on whether the economy is in a low or high inflation regime. 

In a low inflation regime, economic agents practice ‘rational inattention’ (i.e., they ignore relative price shocks, such as energy price spikes, because they expect these to have only a limited impact on their real incomes). As a result, inflation tends to be self-stabilizing. 

By contrast, in a high inflation regime economic agents are on the lookout for signs of inflation and adjust their behaviours accordingly. As a result, agents’ inflation expectations tend to converge with the actual inflation rate, with prices across the economy acquiring a large common component. Wages and prices start to develop a feedback loop, and energy price shocks pass through to the whole economy. 

This is why the passthrough from energy to core inflation disappeared in the 1990s and reappeared with the pandemic. The oil price shock of 2021-22, and the belated policy response, moved the US economy from a low to high inflation regime. This can be seen in the development of a wage-price feedback loop (Chart 5). 

Since mid-2022, the energy-core inflation and the inflation-wage feedback loops have worked in reverse due to energy prices falling. But with energy prices stabilizing, the feedback loop is likely to turn positive again. 

Stagflation Reflects Policy Tightening and Inflation Inertia 

I have explained why the energy price shock of 2021-22 led to a spike in core inflation, stronger workers’ bargaining power, and a high inflation regime, but not why it did not trigger a recession (i.e., stagflation). 

Stagflation is not always caused by oil shocks (Chart 6). Rather, stagflation happens when recessions occur during a high inflation regime. This could be because recessions have only a lasting impact on inflation to the extent that they impact inflation expectations. Even then, disinflation can take several years as shown by the post-1981-82 disinflation: it took 15 years for core PCE to fall from 10% to 2%. 

Oil shocks are also neither necessary nor sufficient for stagflation. For instance, the stagflation of 1969-70 was not caused by high oil prices. Instead, it was caused by a combination of fiscal and monetary tightening (Chart 7).    

Conversely, the 2021-22 oil shock was not followed by a recession largely because monetary tightening started only in March 2022 and was offset by fiscal easing: the budget deficit troughed in mid-2022. Additionally, the collapse in the household savings rate partly offset the impact of the 2021-22 fiscal consolidation. 

Market Consequences 

This discussion suggests that, on balance, the combination of strong growth and sustained inflation is more likely to continue than become stagflation. Oil prices have barely increased year-on-year, and upside risks could be limited. At the same time, fiscal policy is unlikely to get tightened coming into an election year. Lastly, the Fed has signalled that it intends to implement only one more hike. 

This macro backdrop is more supportive of equities than bonds. Nevertheless, as more data showing strong growth becomes available, uncertainty and risk premia could fall and both bond and stock markets could stabilize. 

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)