The Ten Steps of Stagflation

L ast week, markets collapsed, and the media seemed dumbstruck when inflation “surprised” on the upside. There should have been no reason for surprise, however. We are in a straightforward stagflationary spiral. Everything that is happening makes sense and is following a predictable historical pattern. But for those who have doubts, let’s dig deeper into the simple economics of the world we are living in.

Step 1: The inflation shock

The first place to start is inflation. Inflation is higher now because the Biden administration overstimulated an already hot economy with runaway spending, while it was attacking supply with heavy regulation and tax hikes. The Fed accommodated this move, so it was simply a textbook example of a “helicopter drop.” The one objection to this is that helicopters are rather small, and the stimulus was enormous, so it was more like a drop from the C-5, our military’s biggest transport plane.

Step 2: Real wages decline

One of the most widely accepted relationships in economic history is that between wages and prices. Wages lag prices. When prices rise quickly, workers’ real wages decline. Real average hourly earnings in the U.S., for example, are down 2.8 percent over the past 12 months.

Step 3: Consumption declines

With real wages down, consumers will not have enough money to maintain their standard of living. A typical American household would have to spend $460 per month to keep their real consumption at the level it was a year ago. They can’t, so consumption drops.

Step 4: Real GDP declines

Since consumption is the lion’s share of GDP, slowing consumption leads to declining GDP, which we have seen for the last two quarters.

Step 5. Productivity collapses

At the beginning of the recession, firms want to reduce their real labor costs, but since prices are rising and wages are not, they do not have to lay off workers. But since consumption is declining, the same number of workers are contributing to less aggregate production. So productivity nosedives. These forces are truly out of control in our economy right now, which is why productivity posted its biggest drop since 1947 in the first quarter of this year.

Step 6: The Fed acts

The Federal Reserve’s economists will continue to make implausibly low forecasts of inflation and implausibly high forecasts of growth until reality smacks them in the face. This means the Fed will be behind the curve. But it will eventually have to act more aggressively than it otherwise would have because it has spent so much time in denial. When that occurs we get something like ¾ percent rate hikes — and probably a lot of them. In terms of the trail map of the stagflationary tour, You Are Here.

Step 7: The economy nosedives

Now interest-sensitive indicators such as home sales and business fixed investment start to head down. Since consumption is already on the way down, the GDP numbers get very bad indeed. With mortgage rates above 6 percent, and mortgage initiations approaching historic lows, this effect is beginning to kick in now.

Step 8: Price inflation drops to the level of wage inflation

The decline in demand reduces price pressures, but firms have only just begun to increase wages, and they can’t let prices increase at a rate that is lower than wage inflation without hemorrhaging cash. This means that inflation should start to decline to about 6 percent.

Step 9: Unemployment jumps and wage pressures abate

After the Fed has increased rates to the point where they are truly contractionary — that is, when the real interest rate is above the inflation rate — then firms have to start laying off workers and opposing wage increases. This phase is probably about three to six months off.

Step 10: The recession ends

When the recession ends, inflation is finally back under control.

Sadly, the last step is so far off, I just don’t know what to say. But if you keep an eye on the steps you will see it coming before everyone else.