The Automatic Destabilizers of a Stagflationary Economy

Peter's Market Rap for the Week Ending November 17, 2023

Hi. Peter Navarro here with this week’s economy and market rap for the week ending November 17, 2023.  And yes, after a surprise sharp rally over the last three weeks that tallied up almost $3 trillion in gains for stocks, the S&P 500 gapped up on Monday on good inflation news but otherwise remained flat for the week.  So what’s next?

To answer that question, let’s talk a little bit about stagflation and the concept of “automatic stabilizers” over the course of the business and stock market cycles.

Remember here that stagflation is simultaneous inflation AND slow growth or recession.  Stagflation is not the norm as one rarely sees both inflation and recession at the same time.  This is because recessions usually quickly tame any inflationary pressures.

An economy free of stagflation tends to stay in expansion until it begins to overheat.  That’s when central bankers come in to tap on the brakes by raising interest rates.

If the dose of monetary policy is just right, the economy will continue to expand, albeit at a slower rate and inflation abates.  If rates rise too fast or too high, the result is a recession and inflation falls far more quickly.

In either scenario, there are “automatic stabilizers” on the fiscal policy side that usually help an economy recovery, often very quickly.

With these fiscal policy automatic stabilizers, as an economy slows and unemployment rises, government assistance programs kick in.  These range from more welfare and food stamp recipients to more folks on unemployment benefits.  These programs provide a nice little consumption boost offset to recessionary forces.

With monetary policy, if inflation abates quickly, the Fed will quickly lower rates to restart investments on the business side and big ticket item purchases of cars or houses on the consumer side.  You can think of this dynamic as a quasi-automatic stabilizer – quasi because the degree of stabilization depends how quickly the Fed acts.

Now here is where things get interesting – and relevant for today.  In a stagflation scenario, the fiscal part of automatic stabilizers remains intact.  Government assistance programs kick in as growth slows.

However, in a stagflation scenario, the monetary policy side of the quasi-automatic stabilizer equation can’t come to the rescue in a timely way because inflation remains too hot for the Fed to quickly reverse its contractionary course.  To put this another way, even as the economy is descending into slow growth or recession as it is now, the Fed’s hands remain tied by what are still very significant inflationary pressures.  That’s an automatic DEstablizer!

This is where we may stand right now.  We have had a sustained bout of inflation.  We have a rising chance of a significant recession.  The Fed is unable to quickly lower rates to rekindle what is now a flagging investment and housing sector or to lower credit card debt rates which are now so high they make the Mafia lenders look charitable.

At the core of the Fed’s problem is a hallmark of most stagflation scenarios – a wage-price spiral.  While wages have been moderating of late, this is at best a temporary reprieve as some very lucrative labor contracts will soon begin to bleed into the statistics.  More, these inflationary pressures will last  not for days or months but rather for several years over the course of the labor contracts – think, for example, the recent UAW and UPS-Teamsters  blowout contracts.

Of course, Wall Street is still hoping for a soft landing despite the Fed’s gridlock.  Yet the jury is still very much out on that. 

Meanwhile, interest rates across the yield curve remain up and therefore contractionary.  Expect more and more layoffs, particularly in the financial sector.  That is hardly a recipe for a bullish stock market.

I remain in the conviction that cash is king, any long move into stocks is no better than a roulette wheel, 50-50 gamble, and from where I sit, risk remains to the downside and reward favors the shorts.

That’s it for now.  Be sure and see my killer column debriefing the debacle otherwise known as the Biden-Xi Jinping summit in my Monday Substack.