Is The US Economy Headed Toward Stagflation?
If the US economy walks down the path of high deficit, result will be disastrous.
Something strange is happening in the US economy:
The Fed is cutting rates.
Inflation is (seemingly) cooling.
Market rates remain persistently elevated.
On the surface everything looks well: You have an easing Fed and the inflation is still coming down. Ideal scenario for a soft landing!
Why the hell is market rates not coming down and yields are increasing then?
When you scratch the surface, you see warning signs…
If you have been following this newsletter for a while, you know that we don’t make investing decisions based on macroeconomic forecasts. It’s just a highway to hell.
However, that doesn't mean we shouldn’t try to understand what’s going on. After all, as Howard Marks says, the most important thing in investing is risk control.
Understanding the macroeconomic environment allows us to see the possibilities so we can adjust our position to protect ourselves from potential risks and exploit potential opportunities.
After all, you can’t predict, but you can prepare.
So, what’s wrong with markets?
Well, we printed too much money for too long and we have awakened a sleeping peril.
We all got used to free money so much, including the US government, and now everybody refuses to change habits so the Fed is struggling to control the markets.
What does this mean?
This means that if the Fed can’t control the markets and pull the yields down, the inflation will eventually spike again and the Fed will have to raise already high rates which will result in high inflation, rising unemployment and slow growth, i.e stagflation.
You may ask here, “why the hell the Fed can’t control the market? Doesn’t it set the rates?”
Well, this is what we should first tap on…
What you see isn’t all there is…
People tend to keep believing what they already believe.
Daniel Kahneman calls this WYSIATI: What You See Is All There Is
When somebody presents us a new fact, we tend to explain it by things we already know. Last thing we want to acknowledge is that the things we know are actually wrong.
It’s not a new phenomenon, it’s always been this way.
For over 15 centuries people believed other planets were orbiting the world because Aristotle said so.
People tried to predict the planets' locations based on this model. It didn’t work. What do you think they did when it didn’t work? Did they question the system? Hell no. They thought the planets were orbiting the earth but they were doing this in their own unique ways. They believed this until Copernicus discovered that it was the Sun that all the planets were orbiting.
It’s always convenient to seek refuge in what we think is true.
This is what people get wrong about the Fed…
Most people think the Fed controls the interest rates. It’s only natural as this is what we are bombarded with regularly.
Every once in a while CNBC tells people that the Fed is cutting rates, the Fed is raising rates or the Fed is keeping rates steady.
It’s only natural that people believe the Fed is controlling the rates. As most mainstream knowledge, this is largely wrong.
The Fed doesn’t control rates…
The Fed only controls one rate: Federal Funds Rate.
This is the rate that banks charge each other to lend the excess money they are holding in the Fed. Nothing else.
Fed has nothing to with the rate your local bank charges you for mortgage or the credit card interest rate.
So.. Why do rates generally go down when the Fed cuts funds rate and up when it raises it?
Simple. Because of its dual mandate to keep prices stable and maximize employment, the Fed gets data from other government institutions, and employs the most qualified army of economists to interpret the data to understand where the economy is heading.
Because nobody has tools superior to those Fed has, when it says the economy is heading to one direction, you tend to believe it unless you have a strong reason to do otherwise.
This is why market rates generally follow the direction of the Fed funds rate:
If the Fed is cutting the fund rates it’s like announcing “I will pay less interest to the banks keeping its money in me because inflation is cooling so the money will lose less value in the future.”
What would you do if you were a bank?
If you believed Fed, you would also charge less interest to your customers because money won’t lose as much value. If you don’t have a strong reason to believe otherwise and still try to keep your rates up, you will lose business to other banks that cut their rates.
Bond yields will also decline because investors will be willing to accept less premium thinking that money will preserve its value.
One by one, market rates adjust following the same logic.
Unless most market actors believe otherwise… This is the problem we have today.
But why?
Why doesn’t the market believe the Fed?
Let’s play another scenario:
If you were a bank and believed the inflation wasn’t actually coming down or it would reignite again soon, what would you do when the Fed cut rates?
Would you also reduce your own rates?
Exactly! You wouldn’t. It’s simple: You wouldn’t want anybody to come in and lock a 30-year mortgage at a low rate if you believe the Fed would have to raise rates again soon.
This is what we are seeing today. It’s not that inflation isn't falling, but the market believes it’s temporary.
Just look at how inflation came down in the last twelve months:
There is no problem with that. The problem is that the market believes the Fed will have to raise rates again soon because this decline in inflation isn’t permanent.
Why does the market think inflation will spike again?
Because the US government spending is out of control…
Government spending creates inflation above anything else because when the government pumps money into the market, receivers suddenly have more money to spend buying goods and services. That creates a vicious cycle where increased demand drives prices up.
If there is something worse than increasing government spending, it’s increasing government spending when the economy already runs a deficit.
It’s all so simple. What are you going to do if you run a budget deficit? You will get a loan to close it and you will pay interest in exchange. Governments do the same. They borrow to close the budget deficit and pay interest in exchange. Suddenly you need to create more money to pay your debt which is even more inflationary.
And the US deficit is growing…
The US Deficit-to-GDP ratio is currently around 6% and it’s projected to reach 8% if the government keeps spending the way it has been doing for the last decade.
This is even more dangerous because it coincides with Fed’s quantitative tightening (QT). As you see, the Fed has been consistently shrinking its balance sheet since 2022.
That means the Fed is buying less and less government debt. If the Fed buys less government debt, demand for the government bonds decreases, naturally driving bond prices down and yields up.
Here, we are seeing this play out. Yields aren’t coming down despite cooling inflation and the rate cuts.
This is a recipe for disaster… Imagine what will happen when the treasury has to raise more debt in this market.
Yields in the market are already high so it has to offer higher coupons in the fresh debt issues to attract enough buyers otherwise they will just buy the higher yielding issues already circulating in the market. This means that either the Fed will have to step in and buy the government debt or the government will need to inflate coupon rates to attract buyers which will lead to even more money printing due to higher interest expense.
It doesn’t matter whether the Fed steps in and buys the government debt or the government inflates the coupon rates, both of them are inflationary. The market sees this weak point and positions accordingly:
It knows that the government has to raise debt.
It knows the Fed is not buying it, so it doesn’t rush to accept low yields.
It knows that either the Fed will step in or buy the bonds again or the government will raise the coupons.
Investors know both scenarios are inflationary.
This is literally what’s called the “debt spiral.”
Why would rates come down if there is a high likelihood that inflation will spike again? It wouldn’t, and it isn’t.
Disaster Scenario
Well, what could go wrong is so obvious by now…
If the US Government doesn’t implement serious fiscal discipline and raises more and more debt, either the Fed will have to step in to keep yields under control or the coupon rates will go up. Inflation will spike in both cases.
When the inflation spikes again, the Fed will have to raise already high rates and we will be left with a high inflation and higher than before rates which will suppress the growth and eventually lead to higher unemployment.
We will get:
Slow growth.
High inflation.
Rising unemployment.
Definition of stagflation.
This is arguably the worst one of the economic perils because it’s very hard to fight against. You get inflation, you raise rates; you get a recession, cut rates. Clear prescriptions. But when it comes to stagflation, it’s a double edged sword.
You hike already high rates and unemployment will explode.
You cut rates and inflation will go out of control.
There is no clear policy, there are only things that worked. We saw that in 1970s:
The US got out of the stagflation of the 1970s by aggressively raising rates which resulted in a severe recession in early 1980s. The Fed managed to pull inflation to 5% which restored the confidence in the economy and unemployment started to retreat slowly.
However, you should note that the fact that the debt spiral the US Government is going toward could end up in stagflation doesn’t mean we are set for it. Despite the lack of fiscal discipline, the US economy is still in better shape than any other developed economy in the world.
Given its strength, there are still many paths where we don’t get stagflation.
Silver Lining
Before everything, it can cut government spending and thus effectively reduce the amount of debt it needs to refinance at every following cycle. This way it can gradually reduce its budget deficit to around 3% and then safely inflate its debt away every year without upsetting the price stability.
If you get a budget deficit of around 3% with 2%-2.5% annual inflation, you will basically have a pretty balanced budget that is sustainable.
The other way to get there is increasing the tax. It's like paying your debt from your equity pool instead of refinancing it.
Well, repercussions of this are obvious. What would you do if you spent more of your equity to pay your debt? You would spend less of your equity in investments. If the US raises taxes, investments will naturally decline so the growth will slow down.
Trump doesn’t want this. Instead he is committed to cutting taxes so this is a pretty unlikely scenario.
But… There is another way the US deficit could narrow: Rapid productivity growth.
It is so simple: What happens if your income grows faster than your expenses? If you had a budget deficit, it narrows; if you had a balanced budget, you start giving surplus.
It's the same for countries too. In times of rapid productivity growth, the budget deficit can still narrow even if they don’t cut back much on expenses.
Guess what? Productivity is growing much faster in the US than other developed countries.
It is set to grow even faster now due to the new discoveries in AI and adaptation of AI tools in workflows.
McKinsey projects that if the US can reclaim 1948-2019 average productivity growth of 2.2%, this could generate $10 trillion additional value for the US economy in the next 5 years.
And guess what? It’s really hard to get a stagflation with such a high level of productivity growth if you don’t knowingly skyrocket the inflation.
So, as you can see, there are still many ways the US can avoid getting into a vicious cycle of high inflation, high unemployment and low-growth. However, even if all these paths individually looks sufficient to cut the deficit and avoid an inflationary cycle, I don’t think either the US will aggressively cut government spending to reduce deficit nor productivity growth will reach high enough levels to single-handedly reduce deficit.
What is most likely is a combination of both. The Trump administration will probably want to try reducing government spending a bit and the productivity in the US will keep growing a bit faster than other developed countries. Combination of them will likely keep the deficit under control. This is the most likely course.
Conclusion
The market is in a hidden distrust that isn’t strong enough to push investors exit the equities in the middle of a new technological boom but strong enough to keep them on guard.
This manifests itself as high market rates, especially high bond yields, which means that the investors are skeptical that the cooling in the inflation will be permanent. The biggest risk here is the increasing US deficit. If the US keeps moving in this way at full speed, a spike in inflation is not a question of “if” but “when” because of the capital market dynamics explained above.
That path could in theory lead to a stagflation or successive cycles of severe inflation followed by a severe recession. However, I don’t think we are definitively headed toward that scenario. US economy has its unique strengths:
Reserve currency,
Rapid innovation,
Faster productivity growth,
Dominance in new technologies.
These strong fundamentals alone or accommodated by a slight decrease in government spending can be sufficient to avoid that faith.
Overall, the US economy gives more reasons to be an optimist than a pessimist. Yet, investors should always be aware of the risks while keeping optimism so we can quickly change our positioning when the risk profile deteriorates.
As Howard Marks says, you cannot predict but you can be prepared.
Thanks for the info! Never heard of this before and it’s really interesting!
Do you think that trumps ‘plan’ to replace income tax with tariffs will help or hinder the economy?
So we need AI and AGI to save us from the sins of low rates for so long.
Very good article.