Is Stagflation Coming?
Add a Pinch of Tariffs and a Dash of Rate Cuts
What is stagflation?
A country is said to be experiencing stagflation when it is experiencing low levels of economic growth, high levels of unemployment and high levels of inflation. This is where the term “stagflation” comes from, it refers to a situation of a stagnant economy and high inflation.
What is stagflation so bad?
Stagflation brings serious economic pain.
Think of what your life would be like if you lost your job today, knowing you are facing a very weak labor market while at the same time the prices of food, energy and other essential goods begin to increase.
Odds are you would not be very happy. Nobody is happy during times of stagflation which is what led to the creation of the “Misery Index” which is equal to the inflation rate + the unemployment rate.
Could we be heading for a period of stagflation?
For stagflation to occur, two things need to happen at the same time.
- Inflation needs to increase
- Unemployment needs to increase
The trade war the U.S is currently fighting might provide the exact ingredients required to brew up a painful batch of stagflation. Let’s examine how the trade war could impact each of the ingredients for stagflation to occur.
The U.S recently increased tariffs on Chinese goods for the third time in the past year. There are now 25% tariffs on $250 billion worth of Chinese goods. Thankfully The U.S backed off its threat to apply 5% tariffs (which may have risen to 25%) on all Mexican imports into the U.S which totals $372 billion.
If the U.S had followed through on these Mexican tariffs, the value of goods that American businesses would have had to pay tariffs on would have risen to $625 billion.
While American businesses pay the “upfront” cost of tariffs, businesses that have the ability to set prices would pass along as much of that cost as possible to the American consumer.
A tariff is a tax and like any tax, businesses will pass along as much of the additional costs as they can to consumers through higher prices.
The operative word there is “higher prices”. Tariffs raise the prices on everyday goods from fruits and vegetables to cars.
Tariffs of this magnitude will lead to increased inflation.
Typically, prices and inflation rise as a result of increased consumer demand. That is not what is happening here. The tariffs artificially raise the price of imported goods, regardless of consumer demand.
This leaves businesses with one of two bad options.
- Increase their prices (and watch their sales drop)
- Eat the cost of tariffs (and watch their profits drop)
Either option will mean businesses will have less money to reinvest and expand. They also may need to begin cutting cost, which means laying workers off.
What has me worried are the comments recently made by the Chair of the Federal Reserve where he hinted the Federal Reserve may cut interest rates if the trade war gets out of hand.
The Fed typically cuts rates when it feels the economy needs a boost, which it will if the trade war continues to escalate. The downside is that rate cuts increase the possibility for inflation, which would already be elevated due to the tariffs.
If this happens, things could get ugly. In this scenario, the Fed would have to choose between its two mandates.
- Stimulating the economy when needed
- keeping inflation in check
A tariff induced period of stagflation would force the Fed to choose one, it cannot do both.
- If they cut rates, they will boost the economy but increase inflation further
- If they raise rates, they will bring inflation down, but the economy could slip into a recession
What is a Fed Chair to do?