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Moody's Talks - Inside Economics

August 30, 2022

Bonus Episode: Deep Dive - Stagflation

In this bonus episode Mark, Ryan, and Cris discuss all aspects of stagflation, including the definition, the causes, and what they're watching to assess the risk of this scenario.

Follow Mark Zandi @MarkZandi, Ryan Sweet @RealTime_Econ and Cris deRitis @MiddleWayEcon for additional insight.

Mark Zandi:                      Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by my two co-hosts Ryan, Ryan Sweet. Hi Ryan, how are you?

Ryan Sweet:                      I'm good. I'm down at the beach.

Mark Zandi:                      Yeah.

Ryan Sweet:                      So no complaints.

Mark Zandi:                      You look like a beach bum.

Ryan Sweet:                      Yeah, my whole family, we're all beach bums. We could stay on the beach for weeks.

Mark Zandi:                      How long did it take you to grow that beard?

Ryan Sweet:                      Since vacation started.

Mark Zandi:                      Yeah.

Ryan Sweet:                      So it's been like a week, a week and a half.

Mark Zandi:                      Yeah, looks like The Old Man and the Sea. I must say, though, you look like you've been pretty weathered there, out in the ocean there, looking for marlin or something.

Ryan Sweet:                      Well, I'm chasing my three kids around. It's not really relaxing. My wife and I can't just sit on the beach and take a nap. We've got to chase them and make sure they don't go too far out in the ocean.

Mark Zandi:                      Yeah, I forgot about those days. Yeah. And that was Cris deRitis. Cris was chuckling. Hey, Cris.

Cris deRitis:                       Yes. Hi, Mark.

Mark Zandi:                      And you're in the office safely.

Cris deRitis:                       I am in the office.

Mark Zandi:                      Any more folks showing up or is it still pretty sparse in there?

Cris deRitis:                       Quite sparse. I think we have three people on my floor today.

Mark Zandi:                      Goodness. Remote work is alive and well at Moody's Analytics, that's for sure.

Ryan Sweet:                      So to give you an idea, there's one more person in Westchester on Cris' floor than there are people in Ocean City, New Jersey. So Dante, he's a couple streets behind us.

Mark Zandi:                      Oh, you're saying colleagues.

Ryan Sweet:                      Yeah.

Mark Zandi:                      Our colleagues, they're all there. Everyone is there?

Ryan Sweet:                      Yeah. We're all down in Ocean City.

Mark Zandi:                      Oh my gosh. So who's doing the work? Is that me, Cris? Cris and I are doing the work.

Cris deRitis:                       They're remote. They are...

Mark Zandi:                      They're remote.

Ryan Sweet:                      Yeah, I didn't say we're not working.

Mark Zandi:                      Yeah, good point. You're on this podcast. Yeah. Well, this is a special podcast, a little bit different than the others. We're going to focus on a topic. The topic at hand is stagflation, high inflation and high unemployment, and we'll come back to the definition of that. This has been top of mind here in the US and really all over the world. Inflation is high most everywhere because of the shocks created by the pandemic and the Russian invasion of Ukraine. And while we've been downplaying the risks that we actually get into a stagflation scenario, we are getting lots and lots of questions from you, dear listeners and so we thought we'd do a deeper dive here and talk about stagflation in a more rigorous way. And that's the purpose of today's conversation, so it's about stagflation and the first thing I think we need to do is define it. Define stagflation. That's kind of a slippery concept. Hey guys, should I take a crack at that? Would you be okay with that if I put my straw man definition out there and you can run with it? Does that sound okay?

Cris deRitis:                       Yeah.

Ryan Sweet:                      Sounds good.

Cris deRitis:                       Go for it.

Mark Zandi:                      All right. Okay. Well, in my mind, there are three necessary and sufficient conditions for stagflation. First, high inflation and high inflation I would say is an underlying inflation rate that is more than a percentage point above the Federal Reserves target. So let's just use CPI, consumer price inflation as our benchmark. I would put the top end of the target, the Fed's target at about 2.5%. So first condition for stagflation is inflation that is consistently above 3.5%, a full point above the Fed's target range. Second, high unemployment and here I would say that would mean an unemployment rate that is more than a percentage point above our estimate of the unemployment rate, consistent with full employment. Right now, I'd put that at about 3.5%. That's current unemployment. Some would put it higher. I think the Fed would put it at 4%, but let's say high unemployment would be anything above 4.5%, probably closer to 5% in the current context. So CPI inflation above 3.5% and unemployment about 4.5%, probably closer to 5%.

                                             And then the third criteria would be you need high unemployment, high inflation for a period of time. Not a month or two or not even just for a few months, it's got to be a while. So I'd say certainly no less than six months, probably closer to nine, 12 months before I'd say, "Okay, we're in an environment of persistently high unemployment, persistently high inflation." And that's the definition I would use. I mean you could combine the high unemployment and high inflation to what has historically been called the misery index. That's just simply take the inflation rate, add the unemployment rate and the two of those things are called the misery index for obvious reasons. I mean, if you have high inflation, high unemployment, that's a miserable economic environment to be in. People don't feel very good about how things are going. And if you use that, that would say by my definition, you'd need a misery index of 2.5% plus 4.5%. That would be 7%. That feels low. I mean, I want to say the misery index has to be double digit, but not necessarily.

                                             I mean, if I told you we were at 3.5% inflation and a 5% unemployment rate between now and the end of 2023, that feels like stagflation to me, at least some variation of the theme. So that's the definition. Okay, so the three criteria, persistently high unemployment above the full employment unemployment rate, persistently high inflation above the Fed's target range, and persistent is the key here. It's got to be at least six months, probably closer to a year before you call it stagflation. What do you think as a working definition of stagflation? Cris?

Cris deRitis:                       Yeah, I think that you hit on all the factors and I think you also hit on the fact that duration matters a lot. It's not just a temporary blip that we're talking about. It's something that is persistent and that there are shades of gray here. It's one thing if unemployment or inflation is just over 2% or closer to 3%. And in addition to that, I would say the trend matters. If things are moving along, but they're slowly improving, that's a different situation than if things are moving the opposite direction. So I think as a framework, it makes sense and then the degree to which we worry depends on the specifics about the duration and the trajectory that we're under.

Mark Zandi:                      Yeah. And I guess you implicitly made a good point in as there's no arbiter of how to define stagflation.

Cris deRitis:                       No.

Mark Zandi:                      I mean, we've been debating recession here for weeks, months and we've all agreed, I think most of us agreed, we have a final arbiter on recession. That's the Business Cycle Dating Committee, a group of academic economists at the National Bureau of Economic Research, but they're not going to sit there and say, "Oh, this is a stagflation." There's no one out there. In fact, what about us? The three of us should be the arbiters. What do you think of that?

Ryan Sweet:                      That works for me.

Cris deRitis:                       I like it.

Mark Zandi:                      Yeah. I like it too. Yeah.

Ryan Sweet:                      So your misery index, right now is at 12%.

Mark Zandi:                      Yeah, but I wouldn't call this stagflation, right?

Ryan Sweet:                      No, I wouldn't call it either. Because late '70s, early '80s, probably the last time we had stagflation was 22%.

Mark Zandi:                      Yeah, but going back to my definition, it doesn't meet the criteria, because employment is 3.5%.

Ryan Sweet:                      Right, right.

Mark Zandi:                      That's the...

Ryan Sweet:                      Right. Right.

Mark Zandi:                      Full employment unemployment rate. So we don't have high unemployment. We're not even close.

Cris deRitis:                       You need both.

Mark Zandi:                      You need both.

Ryan Sweet:                      Yes.

Mark Zandi:                      It's not right.

Cris deRitis:                       Yeah.

Ryan Sweet:                      Correct.

Mark Zandi:                      And the other thing I'd say is the inflation rate, it is elevated, on CPI inflation it's 8.5% through July, year over year, but it feels like it's coming in here pretty fast. So that's the other thing, to Cris' point, the trajectory doesn't feel like stagflation if we continue on this deceleration path that we're seemingly on right now.

Ryan Sweet:                      Yeah.

Cris deRitis:                       I'd say the misery index is nice rule of thumb, but 1% increase in unemployment matters a whole lot more to...

Ryan Sweet:                      Yes.

Cris deRitis:                       ... consumers' households than 1% in inflation, I would argue.

Mark Zandi:                      Really?

Cris deRitis:                       I don't know.

Mark Zandi:                      I don't know. That's a great question though. Let me ask you that. So 1% unemployment, that means what? How many people does that represent? 1% of the labor force, labor force is 150 million. That would be 1.5 million Americans who lost their jobs, right?

Ryan Sweet:                      That's a recession.

Mark Zandi:                      That's a one percentage point increase in unemployment if it's 1.5 million people unemployed.

Cris deRitis:                       Yeah.

Mark Zandi:                      1% increase in inflation. What is income? What's nominal income now? I want to say.

Cris deRitis:                       [inaudible 00:10:04] percent on that.

Mark Zandi:                      Maybe you can look that up. I'm not sure.

Ryan Sweet:                      I'm doing it right now.

Mark Zandi:                      Okay.

Ryan Sweet:                      You want nominal?

Mark Zandi:                      Yeah, nominal income, total personal income. Because I'm going to take 1% of that and that's the loss of purchasing power. Right? I mean, that's how I would do it.

Cris deRitis:                       Yeah.

Mark Zandi:                      Right. I'm going to [inaudible 00:10:25].

Cris deRitis:                       Is our first order effects, right?

Mark Zandi:                      I'd say personal income is $17 trillion. I'm just saying. I should get a cowbell if I'm right.

Ryan Sweet:                      You're way off. $21.7 billion.

Mark Zandi:                      Trillion?

Ryan Sweet:                      Trillion, trillion.

Mark Zandi:                      Trillion.

Ryan Sweet:                      Yep.

Mark Zandi:                      Oh, because GDP is like $21 trillion, right? So income, is that really?

Ryan Sweet:                      It says nominal personal income. Personal income in outlays.

Mark Zandi:                      It really is $21 trillion?

Ryan Sweet:                      As of June.

Mark Zandi:                      Okay, anyway. Okay, so 1% of that is $210 billion, right?

Cris deRitis:                       Billion. Yep.

Ryan Sweet:                      That's a cowbell.

Mark Zandi:                      What's a cowbell? 1% of $21 trillion?

Ryan Sweet:                      Doing 1% [inaudible 00:11:13].

Mark Zandi:                      You've got a low bar.

Ryan Sweet:                      Maybe it's because I'm on vacation.

Mark Zandi:                      You've got a low bar. So it's the difference between 1.5 million unemployed Americans or a loss of $210 billion in purchasing power for all Americans and you're saying the one percentage point on unemployment feels worse than the one percentage point on inflation? Okay. All right. That's an interesting question though. I'm not sure, but fair enough. Fair enough.

Cris deRitis:                       It depends where you're at as well, of course, right?

Mark Zandi:                      Yeah. Yeah, sure.

Cris deRitis:                       Moving from, if you're at 19% inflation and you go to 20%, who cares?

Mark Zandi:                      Oh my gosh, don't even. I don't even want to visualize that possibility. Yeah. But yeah, I hear you.

Cris deRitis:                       Well, we're going to go global in a moment here, right?

Mark Zandi:                      Yeah. True, good point. Because the stagflation concern is not only here, it's everywhere. But before we go there...

Cris deRitis:                       Yeah.

Mark Zandi:                      So are we all in agreement that, well first let me ask you Ryan, anything else you want to add to the definition of stagflation? The benchmarks I used?

Ryan Sweet:                      No. I think you hit on all of it. I mean, do you think inflation expectations should be factored in? Would they have to become dislodged?

Mark Zandi:                      That goes to the persistency?

Ryan Sweet:                      Okay.

Mark Zandi:                      So I think that's more a cause of.

Ryan Sweet:                      Yeah. No, I see. Yeah.

Mark Zandi:                      Not something I would use to define stagflation, but we'll come back to that, because clearly inflation expectations matter a lot in terms of getting to stagflation. Okay, so we're all in agreement on that and we're all in agreement that at the current point in time, we are not experiencing stagflation, because unemployment is just too low.

Ryan Sweet:                      Correct.

Mark Zandi:                      We're creating too many jobs and unemployment is low. The inflation is painfully high, but the labor market's very strong. You would agree with that?

Ryan Sweet:                      Correct.

Mark Zandi:                      Yeah, okay. All right. What about Europe? I mean, I guess the same thing at this point in time. Unemployment's still pretty low in most of those countries, even though a recession seems more likely. But inflation is higher now in most of those countries, like the UK.

Ryan Sweet:                      Yeah.

Mark Zandi:                      Yeah.

Cris deRitis:                       I would say some countries are already in stagflation, like in Estonia.

Mark Zandi:                      Oh, you would?

Cris deRitis:                       Yeah. Estonia with the double digit. What, I think 18%, 19% inflation and I think the unemployment rate is probably 5%, 6%.

Mark Zandi:                      Hey, Ryan, that deserves a cowbell. Estonia, really?

Cris deRitis:                       Well, we talked about it a couple podcasts ago.

Mark Zandi:                      Did we?

Cris deRitis:                       I'm going off memory.

Mark Zandi:                      Oh, is that right?

Ryan Sweet:                      Estonia, yeah.

Mark Zandi:                      Yeah.

Cris deRitis:                       Anyway, I know it's elevated because of all the exposure to Russian gas that they have. It's very acute there.

Mark Zandi:                      Right, right.

Cris deRitis:                       And if you go a little beyond Europe, I get Turkey, certainly. I think you'd classified that as being in stagflation.

Mark Zandi:                      Right. Actually, I don't know. I know the inflation rate is very high. I didn't realize, is unemployment that high as well? Well above its full employment unemployment rate? I didn't know that.

Cris deRitis:                       I believe so.

Mark Zandi:                      You believe so.

Cris deRitis:                       That's a good question.

Mark Zandi:                      Yeah, okay. All right. So there are cases, small number and small countries, but there are some cases overseas that if they're not in stagflation, they're pretty close, even by our definition. And just if we're going cross country, I'm going to point out that the full employment unemployment rate varies a lot from place to place. It's much higher in much of Europe compared to the United States. So a 3.5% unemployment rate in Europe would be well beyond full... [inaudible 00:14:55] past full employment, but there's differences there. Okay, let's then ask the question. What are the causes of stagflation? How do economies get into this mess? And of course, in the US, the last time we were in a stagflation environment, at least by our definition, that would've been in the second half of the '70s and the first half of the 1980s. What is all the underlying causes of stagflation? Cris, you want to tackle that?

Cris deRitis:                       Yeah, sure. So I would say broadly speaking are two causes. One is a supply shock like the oil shocks that we experienced in the '70s and the second is some type of policy error. And it's probably the combination of those that really enhances or leads to a truly miserable stagflation environment and that's what happened during the '70s in the US. We had these supply shocks around oil and at the same time, we had monetary policy errors in terms of the Fed easing when they should have been tightening. We had price controls on the fiscal side, you had some policies also that were certainly contributing to additional inflation, so wage and price controls, that certainly was problematic. What else happened? We had the gold standard. We transitioned off the gold standard, so depreciation with dollars. So that transition period also likely contributed to the situation as well. Maybe as one offs, each one of those might have been handled appropriately, but it really was that combination of all those factors that led to a particularly painful stagflationary environment.

Mark Zandi:                      Right. So maybe you said, but I'll provided more of a framework around it.

Cris deRitis:                       Sure.

Mark Zandi:                      But I think the first thing you said is a supply shock, so that's a hit to the supply side of the economy and back in the '70 and '80s, that was primarily oil.

Cris deRitis:                       Yeah.

Mark Zandi:                      OPEC Oil embargo, the Iranian revolution. In the current context, that would be the Russian invasion of Ukraine, the higher oil and ag and commodity prices and the pandemic, so there's some similarities there.

Cris deRitis:                       Right.

Mark Zandi:                      The second you said is a policy error and I guess there you're focusing on the Federal Reserve. They didn't see this, back in the '70s and '80s, they didn't understand or see, because stagflation was not something that we had experienced. They didn't understand it and they were trying to figure out how do they respond to this supply shock? Do I raise interest rates to slow growth to combat the high inflation? Or do I worry about the high unemployment and I ease lower interest rates to try to help the economy out and bring down unemployment? Two very different policy prescriptions and obviously they got it wrong.

Cris deRitis:                       Yeah. Stagflation wasn't even allowed in the model.

Mark Zandi:                      Wasn't even allowed in the what?

Cris deRitis:                       In the original Keynesian models. There was no provision for stag. It wasn't possible under that framework.

Mark Zandi:                      Yeah.

Cris deRitis:                       Yeah. This trade off of unemployment and inflation.

Mark Zandi:                      Yeah. Good point. Yeah. You had that very clear Phillips Curve, so called Phillips Curve. Yeah and I guess the one thing that contributed to that mistake was a complete misunderstanding or no understanding, or even no thought of this concept of inflation expectation.

Cris deRitis:                       Yeah. That's right.

Mark Zandi:                      And Ryan, do you want to explain that? What that is and why that's so important?

Ryan Sweet:                      Why inflation expectations are so important?

Mark Zandi:                      Yeah and how we think about that now.

Ryan Sweet:                      There's a couple ways that we look at and measure inflation expectation. You can look at surveys of the consumer. So University of Michigan, for example, have ask consumers what their expectations for inflation one year from now, five to 10 years from now. And what gets embedded in people's inflation expectations are the prices that they see on a daily basis, so it's gasoline prices, it's food prices. But the Fed also looks at market based measures and inflation expectations and I think the three of us pay way more attention to market based measures, because that's where the bond investors are putting their money where their mouth is. And why inflation expectations are important is that it gets embedded in people's behavior. Consumers alter their behavior depending on where they think inflation's headed in the medium term and businesses do the same, so that effectively will determine how people behave now is their expectations of where prices are headed down the road.

Mark Zandi:                      Yeah and I guess in the '70s and '80s, there was not even a concept of inflation expectation. I guess that concept was born out of that period and people realize, "Oh my gosh, if inflation gets embedded in people's expectations about future inflation, it's much more likely that inflation will be realized and get embedded, entrenched in the economy." And so-called Phillips Curve's relationship between unemployment and inflation shifts. It moves out because of the shift in inflation expectations.

Ryan Sweet:                      And in the '70s and '80s, how would you measure market based measures of...

Mark Zandi:                      I don't think you could.

Ryan Sweet:                      You didn't have TIPS. You didn't have treasury inflation protected securities back then.

Mark Zandi:                      Right. I guess you could tease it out of the bond market. You could do long term interest rates, I guess. I think you could.

Ryan Sweet:                      Yeah, you could probably decompose the tenure.

Mark Zandi:                      Yeah, tenure treasury yield into the constituent components and kind of back out inflation expectations. Yeah.

Ryan Sweet:                      The residual, yeah.

Mark Zandi:                      But certainly no one was doing that at the time.

Ryan Sweet:                      No, and it wouldn't be as clear cut as using TIPS today.

Mark Zandi:                      Yeah and I guess it's [inaudible 00:20:54].

Cris deRitis:                       They didn't have the real time data.

Ryan Sweet:                      Right.

Cris deRitis:                       Or you'd be making a host of assumptions.

Mark Zandi:                      Yeah. Right. And I guess the other concept that we now have a pretty good understanding of that was born in that period that's related to high inflation expectations is the wage-price spiral.

Cris deRitis:                       Right.

Mark Zandi:                      So if workers think inflation's going to be high in the future, they go to their employer and they say, "Look, my cost of living is rising quickly. I have to pay more to commute into work. I have to pay more for my clothing and to take care of my kids so I can come to work. You, Mr. or Mrs. Employer, Miss Employer, you've got to pay me more to compensate for that." And then the business person says, "Oh, okay, Mr. or Miss Worker, I'll pay you more," because they think that inflation's going to be high. They can pass along their higher costs in the form of higher prices and you get into this self reinforcing negative wage-price, what we call spiral, wage-price spiral and that is all a result of these higher inflation expectations. And once you get into that dynamic, then you get into this high inflation, unsustainable economic environment where the economy starts falling apart and unemployment starts rising and you got this bad, very noxious combination of high inflation and high unemployment. But in the [inaudible 00:22:22].

Ryan Sweet:                      Yeah, so Mark, it's getting kind of expensive to drive in. It's getting expensive at the grocery store. Cris and I could use...

Mark Zandi:                      Yeah, but your inflation expectations are well anchored, I would say.

Ryan Sweet:                      Oh, they're anchored. Yep.

Mark Zandi:                      Yeah. They're well anchored. You know they're coming back in.

Ryan Sweet:                      Yeah, I know.

Mark Zandi:                      Yeah, yeah. So that doesn't work with me, that argument. Here's the third thing though, I'd say. So Cris, you said causes.

Cris deRitis:                       Yep.

Mark Zandi:                      First supply shock, second policy error.

Cris deRitis:                       Meaning both monetary and fiscal.

Mark Zandi:                      Monetary and fiscal.

Cris deRitis:                       Yeah.

Mark Zandi:                      And oh, on that front, going back to Europe, that feels like that could be an issue. I mean, in terms of both monetary and fiscal policy.

Cris deRitis:                       Yeah.

Mark Zandi:                      We were talking about that today. Earlier we had a meeting of international economists, our international economists and we're talking about particularly the UK, they're thinking about because Boris Johnson's out and somebody else is coming in and that I guess the leading candidate wants to pass fiscal support to help with the cost of the higher energy cost that they're facing. And that's so-called fiscal stimulus, borrowing money to provide this cash to households, to navigate through. But that runs counter to the policy prescription that you would think you would follow, because if inflation is high, you want to get inflation down. But they are juicing the economy with this extra stimulus. It's understandable what they want to do. People are hurting and they don't want them to hurt. Particularly low income households have a big energy bills, particularly as winter approaches and they want to help them. But the result of that may be it keeps inflation persistently high, exacerbates the inflation expectations. And it feels like the UK has a much greater risk of going into stagflation because of that policy.

Cris deRitis:                       Yeah.

Mark Zandi:                      Would you consider that a policy error then?

Ryan Sweet:                      Yes.

Cris deRitis:                       Yeah.

Mark Zandi:                      You would. Okay.

Cris deRitis:                       There's also talk of price controls across the continent as well, right?

Mark Zandi:                      Oh, really?

Cris deRitis:                       I don't know that they're... Certainly there's party. There's a lot of elections going on.

Mark Zandi:                      Oh, only you guys in Italy. Those guys, it's probably the Italians are thinking about.

Cris deRitis:                       There's always some party in Italy that...

Mark Zandi:                      Some party.

Cris deRitis:                       ... advocates for any old policy.

Ryan Sweet:                      Did price controls work in the '70s and '80s?

Mark Zandi:                      They did not. They did not.

Ryan Sweet:                      Yeah. I didn't think they worked.

Mark Zandi:                      Briefly, and they just exacerbated the problem.

Cris deRitis:                       Yeah. They work until they don't.

Mark Zandi:                      Well, here's the third factor I'd throw in though, the third cause. And this is maybe a big difference between now and then in the '70s, '80s is some structural factors of forces, and maybe you mentioned this, in the economy that reinforced the wage-price dynamic. So for example, if you go back in the '70s, '80s, the economy was much more manufacturing based, construction based. It was highly unionized, but more importantly, a lot of the labor contracts had so-called cost of living adjustments, so-called COLAs. So workers got automatic increases in their wages when inflation was high. So that served to reinforce this formation of this wage-price spiral. And of course, which is at the heart of the stagflation scenario.

Cris deRitis:                       You see that as a consequence of unionization?

Mark Zandi:                      No. Well, not necessarily. I think it was well intentioned.

Cris deRitis:                       Yeah.

Mark Zandi:                      In a low inflation environment, you're saying, "Hey guys, you, employer, you've just got to compensate for inflation plus whatever productivity growth I get." So I don't think per se that's a bad thing, except if you get into this stagflation environment with the supply shock, and then all of a sudden, it's a turbo charger on this wage-price spiral and causes all kinds of problems. And so I think as a result of the experience of the '70s and '80s and the monetary policy response to wring that out, a lot of those COLA contracts got broken and COLAs, I think, I don't know what share of contracts have those today, but I would imagine pretty small, not many.

Ryan Sweet:                      And I mean, the biggest one that comes to mind is the Federal Government.

Mark Zandi:                      Do they have cost of living adjustments in those contracts? I don't know.

Ryan Sweet:                      I believe so.

Mark Zandi:                      Oh, really? Are you sure? Yeah.

Ryan Sweet:                      No, I'm not 100% sure.

Mark Zandi:                      Yeah.

Ryan Sweet:                      But whenever, I forget what month it is, you can calculate the COLA adjustment, in every January the personal income report talks about the cost of living adjustment for federal workers. I don't know if it's everyone, it's just... I can pull it up.

Mark Zandi:                      Yeah. Well, social security, certainly.

Cris deRitis:                       Yeah, there you go.

Ryan Sweet:                      That's a big one in COLA.

Mark Zandi:                      That's definitely the case. Yeah. Every social security recipient gets a one year bump related to the last year's inflation rate. So all the social security recipients this year are going to get a big increase, right?

Cris deRitis:                       Right.

Mark Zandi:                      Because based on last year, the inflation rate, as of, I think now. They're going to reset it pretty soon. I think it's in August or something where they use that month to figure out what the cost of living adjustment's going to be. But that's a good point. And I guess there are other structural differences between now and then.

Cris deRitis:                       Well, we clearly aren't as dependent on oil or energy.

Mark Zandi:                      Right.

Cris deRitis:                       As an economy and certainly not as much on foreign oil.

Mark Zandi:                      Yeah.

Cris deRitis:                       So there's some insulating effect, which may be a reason why we haven't experienced an even worse situation given what's going on in the energy markets.

Mark Zandi:                      Right. Okay, so supply shock.

Cris deRitis:                       Yep.

Mark Zandi:                      Now, considering what's going on now and whether there's the fodder or the groundwork for stagflation developing in the current environment, certainly supply shock, we've got that. I mean...

Cris deRitis:                       More than one.

Mark Zandi:                      More than one.

Ryan Sweet:                      We've got plenty.

Mark Zandi:                      Yeah, feels even worse than what happened in the '70s and '80s. Well, of course, as you say, oils were much more important back then so maybe it's the same, roughly the same thing. But we've got the pandemic disrupting global supply chains in labor markets. That's a massive supply shock. Fading, but still playing a big role. And second, the Russian invasion that's higher oil, natural gas, agricultural, metals prices. So two massive shocks to the supplies side of the economy. So we've got that. I guess the structural difference, there are big structural differences. It doesn't feel like we're in the same kind of league, so that would suggest stagflation would be less likely now than in the '70s and '80s. And that gets to the policy response, I suspect is the big difference between now and then.

Ryan Sweet:                      Yeah.

Mark Zandi:                      Right, right. And Ryan, so do you want to talk about that? I mean, what is the appropriate policy response to an environment where stagflation might become more of an issue?

Ryan Sweet:                      Well, I thought you laid it out well earlier in that the Fed really doesn't have a playbook for stagflation. Central banks in general, don't have playbooks for stagflation because it's their worst nightmare, because how do they respond? Do they raise interest rates to slow the economy down, to bring inflation back down closer to their target? But at that, if they do that, then unemployment continues to rise. Or vice versa, do they cut interest rates to stimulate the economy to reduce unemployment? But then that would juice inflation higher. So the Fed's response in the '70s and '80s was just jack up interest rates as quickly as possible, as aggressively as possible to wring out inflation, but that pushed us into a recession. So there's no playbook for that. And that's why, later on, when we talk about stagflation odds in the US, they're low because the Fed's facing Hobson's choice. Either push the economy into a recession to avoid stagflation, or risk the economy eventually falling into a period of stagflation.

Mark Zandi:                      Well, I guess in the '70s and '80s, the policy response was first in error. Because here's the thing we probably should have said earlier, the high inflation that developed in the late '70s and early '80s actually started all the way back in the '60s, right?

Ryan Sweet:                      Yeah.

Mark Zandi:                      And the '60s inflation coming into the '70s was felt more like it was demand driven. You had a Vietnam war, you had the Great Society. You had a lot of government spending, expanding fiscal deficits and debt, and it pushed the economy past full employment and wage and price pressure started to develop. Then you got into the '70s and I think in 1973, you had the first oil embargo and that caused oil prices to go skyward and we were much more dependent on oil back then and then another round of spikes in 1980. The Fed didn't really understand the dynamics here was more focused on the impact of these shocks on growth and high unemployment accommodated with easier policy, trying to keep the economy moving and keep unemployment down. But that just exacerbated the inflation and it got to a place so that by 1979, 1980, when Paul Volcker finally became Fed Chair, we had, I think back then 15% consumer price inflation and unemployment was headed towards double digits. I mean, we closed in at 10% on the worst of it in the early '80s.

                                             And there was a massive change in policy, monetary policy at that point in time, where Paul Volcker said, "No, this just all wrong. We've got to wring out, the inflation's our number one problem. We've got to wring that out and so I'm going to jack up interest rates, meaning we're going to have a doozy of a recession." And we did to wring out those inflation expectations and bring inflation back in. And once we get inflation back in, then we can start worrying about the unemployment and trying to get to the other side of the recession. So that was the mistake and then Paul Volcker really brought the hammer down.

Ryan Sweet:                      Wasn't the Fed less independent pre-Volcker?

Mark Zandi:                      I think that's fair to say.

Ryan Sweet:                      Because you remember reading all those reports and stories about the president trying to influence what the Fed was doing.

Mark Zandi:                      Yeah. I think that's a great point.

Ryan Sweet:                      And then Volcker came in. Yeah.

Mark Zandi:                      So we say policy error, but it was, but it doesn't go entirely to the Fed. It goes to the fact that the Fed was not independent or completely independent from the executive branch. The president had influence over that. It certainly, I think Richard Nixon used his influence aggressively to try to keep interest rates down and obviously that exacerbated things.

Cris deRitis:                       I think it was the inconsistency of the policy as well. That was a lesson learned. First they tightened and then they loosened it. It was just very confusing for businesses and consumers to understand what the policy was. And Volcker...

Mark Zandi:                      Right.

Cris deRitis:                       ... made very clear, "Inflation's job one, this is what we're going to do." There was no ambiguity around it and I think that was also helpful in setting those expectations, getting us back on course.

Mark Zandi:                      Yeah, it's a good point. Good point. Throughout the '70s, central banks couldn't quite figure, "Do I worry about the unemployment? Do I worry about the inflation?"

Cris deRitis:                       Yeah.

Mark Zandi:                      They kept swinging back and forth and you got both high inflation and high unemployment, and nothing worked out.

Cris deRitis:                       Right.

Mark Zandi:                      Volcker said, "Now we're not doing any of that. I'm worried about inflation. I'm letting the economy go where it needs to go to get inflation back down." Yeah and interestingly enough, it took a while to get inflation expectations all the way back down to something the Fed would feel comfortable. I mean, Paul Volcker, I think he was chair of the Fed from 1979 to 1987, I think, and Greenspan followed in 1987 and he continued to... He didn't follow a similar policy. He called it a policy of opportunistic disinflation, where he didn't push the economy into recession like Volcker did, but he said, "If the economy goes into recession, I'm not going to get it out very fast because I want to keep the unemployment rate high and make sure I wring out that wage-price spiral and those inflation expectations." And it finally, probably wasn't until when, well into the 2000s, towards the end of Greenspan's term that inflation finally came back, settled in to where the Fed wanted them, their target.

                                             I guess that's the other thing to point out. Back in the '70s and '80s, there was no inflation target. There was no explicit inflation target. No one said 2% is the number, right?

Cris deRitis:                       It wasn't clear.

Ryan Sweet:                      No.

Mark Zandi:                      No.

Ryan Sweet:                      No. It wasn't until recently that they actually put it in the paper.

Mark Zandi:                      Recent meaning in the last couple of decades. Yeah.

Ryan Sweet:                      Last couple decades. Yeah.

Mark Zandi:                      Yeah, right. So I guess that's the other...

Ryan Sweet:                      And there was no policy statement either.

Mark Zandi:                      Yeah.

Ryan Sweet:                      So markets just had to infer what the Fed was doing by what was going on in markets.

Mark Zandi:                      Yeah, you won't believe this, but when I first started, the Fed never announced what even the federal funds rate target was. You had to figure that out by looking in the market saying, "Where is it trading?" So they wouldn't announce anything. It was completely opaque what they were doing.

Ryan Sweet:                      It wasn't until 1994 that they released their first statement, I think.

Mark Zandi:                      Is that right? Was it [inaudible 00:36:04].

Ryan Sweet:                      Yeah. I thought it was 1994.

Mark Zandi:                      Yeah, that sounds right. Yeah, under Greenspan. Yeah. Okay, so thinking about the causes then, that gets to policy. So we've got the shocks, the supply shocks. Obviously, we've got that, the high inflation. We don't have the same problem structurally. I think we're in a better place there, but it really boils down to policy and we learn from the policy mistakes of the '70s that it makes more sense for the Fed to, if inflation is high, wring out the inflation first, make sure that that's back at their target. Inflation and inflation expectations are back to their target, and then you worry about the economy and where the economy is. And so that's kind of where we are right now, and what that effectively means is the Fed is going to push us into recession sooner rather than later. They're not going to wait if inflation remains high and accommodate it. They're going to fight it and wring it out if that means recession, so be it. Get inflation back down and then once you get inflation back down, then you start worrying about getting unemployment back down.

Ryan Sweet:                      And that's what the Fed has basically been saying. That's what they're communicating is that we're going until we [inaudible 00:37:23].

Mark Zandi:                      Just point blank, right?

Ryan Sweet:                      Yeah.

Mark Zandi:                      I mean, literally, they're telling you what they're going to do. Go look at their forecast. They're saying, "Yeah, we're raising the funds rate 3.5% to 4% in the next few meetings. We're going to wring this out. We're going to wring out this inflation."

Ryan Sweet:                      yep.

Mark Zandi:                      Right, okay. And again, that also goes back to Europe and some questions about whether the European Central Bank is going to be similarly predisposed to do that. I mean, because the Europeans, before all of this, had much lower inflation and much lower interest rates. I mean, they had up until a week or two ago, three weeks ago, they had negative interest rates. So they're obviously now raising rates aggressively, but they're still incredibly low and it seems more likely that they would make a mistake. That they would be slower to raise rates, to wring out that inflation and ensure we don't get into a stagflation scenario. What about on the fiscal policy side? What would be a mistake there at this point?

Cris deRitis:                       Student loan forgiveness.

Mark Zandi:                      Yeah. Okay, so the president announced that today, the student loan program. But there's a lot of cross currents in that, right?

Cris deRitis:                       Yeah. Yeah.

Mark Zandi:                      I don't know that has any bearing on growth or inflation. I mean, you have the debt forgiveness. All else being equal, that would juice growth and inflation, but then you also have the resumption of the payments. There was a moratorium on student loan payments during the pandemic. That is now going to come to an end. That would be a...

Cris deRitis:                       Maybe.

Mark Zandi:                      ... restraint on growth and inflation. Well, maybe? Really, you think?

Cris deRitis:                       They extended it again.

Mark Zandi:                      Oh, yeah.

Cris deRitis:                       So who is to say?

Mark Zandi:                      Yeah, yeah. Right. Good point. But don't you think at this point?

Cris deRitis:                       Well, I've been wrong before.

Mark Zandi:                      Yeah, right. Right. Good point, good point. If they don't, then you're right. It would be to cross purposes of the Fed. But if you let the moratorium expire and payments begin, then you do the arithmetic, it kind of washes out any impact on growth or inflation that you have on the debt forgiveness.

Cris deRitis:                       But the magnitude is questionable. I think that's...

Mark Zandi:                      Small.

Cris deRitis:                       It really depends on the details. If things are extended out longer, how exactly the debt is forgiven.

Mark Zandi:                      Yeah. Good point.

Cris deRitis:                       I think you're right. I think, yeah, you're right. Yes, there will be an impact. How big of an impact really depends on how this thing gets rolled out.

Mark Zandi:                      Yeah. But I guess you would, I mean more broadly you'd say anything, any deficit finance, fiscal support or stimulus would probably be a mistake in the current environment.

Cris deRitis:                       Yep.

Mark Zandi:                      Yeah. I mean, and it feels like everything, any proposal, no matter what it is, is being looked at through the prism of, "What does it mean for inflation?" Like the Inflation Reduction Act, although that doesn't significantly impact inflation in your term and obviously, everything was looked at through that prism. Is it going to significantly... And in that case, it was not deficit financed. It was paid for or more than paid for.

Cris deRitis:                       Yeah. Everything except tax cuts.

Mark Zandi:                      Everything except tax cuts?

Cris deRitis:                       I don't think there would be much interest or discussion around, at least from one side of the aisle, if we propose tax cuts at this point in terms the inflationary consequence, but yeah.

Mark Zandi:                      Oh, okay. Really? Yeah. You guys are a little cynical.

Cris deRitis:                       a little cynical, little cynical.

Mark Zandi:                      Guys, you guys are really cynical. You're so cynical it's over my head. It takes me a while to catch up to it. Geez, Louise. I guess, I suppose you're right though. I suppose you're right. Okay, so what are we concluding here then? Much less likely we're going to have a stagflation scenario here?

Ryan Sweet:                      In the US.

Mark Zandi:                      In the US. Okay.

Cris deRitis:                       Well, a severe stagflation scenario. Under your definition, if it's just 1% increase in inflation, 1% increase in unemployment.

Mark Zandi:                      Yeah.

Cris deRitis:                       I don't know if that's... That's certainly not very remote.

Mark Zandi:                      Yeah.

Cris deRitis:                       Right.

Mark Zandi:                      Yeah. It's not way out there on the tail...

Cris deRitis:                       Yeah.

Mark Zandi:                      .., of possible outcomes. Yeah.

Cris deRitis:                       Yeah. A '70s style stagflation scenario, which I think is what most people have in mind, I think that is pretty far out on the tail, given the Fed's resolved.

Mark Zandi:                      Yeah. Well, that was high single digit, double digit unemployment and double digit inflation. That feels like that's way out.

Ryan Sweet:                      Yeah. Right.

Mark Zandi:                      Okay.

Ryan Sweet:                      Because we used to go back to our rule of thumb, using the misery index. It's a 12% now. That's what it was in 2011 and I don't think anyone would argue that we had stagflation in 2011.

Cris deRitis:                       No.

Mark Zandi:                      Say that again?

Ryan Sweet:                      The misery index is currently at the same level it was in 2011.

Mark Zandi:                      Oh. Oh, I see.

Ryan Sweet:                      Because no one was talking about stagflation in 2011.

Mark Zandi:                      Right. Because inflation was on the floor at that time.

Ryan Sweet:                      Exactly.

Mark Zandi:                      Yeah, right. Okay. And that goes back to my point. It's got to be high inflation, high unemployment.

Ryan Sweet:                      Yeah. Correct.

Mark Zandi:                      Okay. All right, so what indicators should we be looking at to gauge whether we're going down the stagflation path? What would you look at to gauge if that scenario is coming to fruition?

Cris deRitis:                       I'd say the expectations are number one.

Mark Zandi:                      Yep.

Cris deRitis:                       Are they getting unanchored? Are they coming in? As a precursor of where things might be headed and how consumers, investors will change their behavior.

Ryan Sweet:                      And they're anchored.

Mark Zandi:                      Are they?

Ryan Sweet:                      Market based measures of inflation expectations. Have you looked at 5-Year, 5-Year Forwards?

Mark Zandi:                      Well, have you looked at 1-Year, 5-Year Forward?

Ryan Sweet:                      You're cherry picking? No, they're fine.

Mark Zandi:                      I'm not cherry picking. Actually, I was going to ask you, what is your number one favorite measure of inflation expectations? 5-Year, 5-Year Forwards?

Ryan Sweet:                      I mean, that would be probably up top.

Mark Zandi:                      For the long run, right?

Ryan Sweet:                      For the long run.

Mark Zandi:                      That's inflation five years from now.

Ryan Sweet:                      Five years, yeah.

Mark Zandi:                      In a subsequent five year period. So that's way out there in the future.

Ryan Sweet:                      Yeah, and I forget which regional [inaudible 00:43:45].

Cris deRitis:                       And that one is anchored. [inaudible 00:43:45].

Mark Zandi:                      That is anchored.

Cris deRitis:                       I think Ryan's right. No one thinks...

Mark Zandi:                      It's always been anchored though.

Cris deRitis:                       Yeah.

Mark Zandi:                      It never even came close to being unanchored, right? Yeah. Okay.

Cris deRitis:                       One way or another, we're going to get back there.

Mark Zandi:                      Get inflation right.

Cris deRitis:                       Yeah.

Mark Zandi:                      Yeah. Well, they're saying like us, we're not going to have stagflation. That's not happening.

Ryan Sweet:                      Correct.

Cris deRitis:                       Not to that magnitude. No.

Mark Zandi:                      Yeah.

Ryan Sweet:                      Right.

Mark Zandi:                      Okay. So what is your favorite measure? Ryan?

Ryan Sweet:                      5-Year, 5-Year Forwards, and then also...

Mark Zandi:                      Oh, it is? Okay. All right.

Ryan Sweet:                      I forget what regional fed does it. They adjust 5-Year, 5-Year Forwards for the liquidity premium, so it's a real measure of inflation expectations. So that's my number one.

Mark Zandi:                      All right. Okay. That's anchored, you're right. Cris, what's yours?

Cris deRitis:                       I keep an eye on the 5-Year Breakeven, just because it's readily available.

Mark Zandi:                      And explain what that is?

Cris deRitis:                       So that's the difference between yield on a nominal five year treasury and a TIPS five year treasury, so inflation protected.

Mark Zandi:                      Okay. And what's that...

Cris deRitis:                       Security.

Mark Zandi:                      ... right now?

Cris deRitis:                       I don't know what it is right now. I was about to look it up.

Mark Zandi:                      Yeah. Go quickly.

Ryan Sweet:                      I got it.

Cris deRitis:                       Last I looked, it was cut. It certainly had come in, but..

Mark Zandi:                      It was on the high side, right?

Ryan Sweet:                      It was 2.77%.

Mark Zandi:                      Okay. So that's high, right?

Cris deRitis:                       That is high.

Ryan Sweet:                      It was 3.5% earlier this year. It's come down.

Cris deRitis:                       At the start of the invasion.

Mark Zandi:                      It should be no more than... Ideally, you want it 2.5%. No more.

Cris deRitis:                       Right.

Mark Zandi:                      So we're 20...

Ryan Sweet:                      In spitting distance.

Mark Zandi:                      Yeah, okay. Fine. Fair enough. Fair enough.

Ryan Sweet:                      3.5% I would be concerned about.

Mark Zandi:                      Oh, here's the other thing that gives me some solace on that though, Cris. It's five years, so you know inflation in the first year is going to be high.

Cris deRitis:                       Sure.

Mark Zandi:                      So actually, it might actually be 2.5%. So say in the first year, it's high by five percentage points. It's 7.5% in the first year. Divide by five.

Cris deRitis:                       It's coming in.

Mark Zandi:                      No, less than that. If it's five percentage points over divided by five, that's even less than that. What am I saying? I know. No cowbell for me.

Ryan Sweet:                      Yeah.

Mark Zandi:                      Okay. If it's 1.25 percentage points high in the first year and you divide by five, that's 25 basis points per annum, isn't it?

Ryan Sweet:                      Right.

Mark Zandi:                      So that may actually be consistent with two and a half percent. To my point, 1-Year, 5-Year Forwards is one year from now. So forget about the next year, because we know that by definition that's going to be high and it's the five year period after that. And that is, last I looked, on the high side. If you look at the ICE measure, the Intercontinental Exchange, they put together a measure based on breakevens and also on inflation swaps, another way the bond market votes on inflation. And yesterday, that was at 2.8%. That made me a little nervous. That made me a little nervous.

Ryan Sweet:                      I mean, if you look at the inflation swap curve, so what's inflation expectations over various time horizons, for the most part they're saying we're going to get inflation back in the next couple years down to 2%.

Mark Zandi:                      Okay, fine. All right. I haven't looked at the swap curve. Can you just send me the link to something I can look at, or is that off of...

Ryan Sweet:                      It's off my computer. I'll send it to you.

Mark Zandi:                      Okay. Send it to me. Okay.

Ryan Sweet:                      On Monday.

Mark Zandi:                      Yeah. Yeah, yeah. When you get back from your bum beach vacation. Okay, got it. So it's only, we're looking at inflation expectations. I totally get that and right now, we're debating it, but it feels sort of okay. Maybe a little bit on the high side, but within, as Ryan said, spitting distance of where we want it to be, so no big deal. What about wage growth? I think we should be focused on wage growth. I mean, I think in the current context, probably right?

Ryan Sweet:                      Yeah. The Employment Cost Index. That's growing pretty quickly.

Mark Zandi:                      Yeah. You want to describe the ECI? I know we had some past podcasts.

Ryan Sweet:                      Yeah. The Employment Cost Index is a measure of nominal wages in the US. But unlike average hour earnings and other measures of wages, they can adjust for composition changes. So average hour earnings get skewed because if a lot of jobs grow in leisure and hospitality, lower paying industries, that's going to bias average hour earnings one way and vice versa. But the Employment Cost Index adjusts for that, so that's why I think it's one of the best measures of wages along with the Atlanta Fed Wage Tracker, because they kind of do a similar thing to what the ECI does.

Mark Zandi:                      Yeah. And they're both over 5% year over year.

Ryan Sweet:                      Correct.

Mark Zandi:                      Right. And by my calculation, we'd want to see something closer to 3.5%.

Ryan Sweet:                      Yeah and so one thing I'm tracking, what kind of leads the ECI by a couple of months is the quits rate. So when you have a very high quit rate, job switchers, they're typically getting higher pay increases and that's going to juice wage growth. So the quit rate is still very, very high. So it doesn't look like nominal wage growth is going to moderate the next quarter or two.

Mark Zandi:                      Oh, is that right? That's interesting.

Ryan Sweet:                      That's how I forecast the ECI is one of the inputs is the quits rate.

Mark Zandi:                      Does it show any kind of leveling off in growth or is it going to show continuous...

Ryan Sweet:                      Oh, yes. So it's a little bit of leveling off and then I expect the quits rate to come in over the next year or so.

Mark Zandi:                      Right, right. And I said 3.5%. Just for context, that would be 2% inflation plus 1.5% productivity growth. That's 3.5%, if you're at 3.5%, workers are getting their share of the economic pie and that would be consistent with stable 2% inflation. And we're at 5% so I think really we should watch the Employment Cost Index, the Atlanta Fed Wage Tracker. Hopefully we level off around 5% and start to come in and the quit rate is a good third indicator, if that's a good leading indicator, as you say is a good leading indicator of wage growth, which sounds very intuitive. I hadn't looked at that, but that sounds interesting.

Ryan Sweet:                      What about the Beveridge curve? So the Beveridge curve is the relationship between job openings and the unemployment rate. So where we are right now, we have very high job opening rate and a very low unemployment rate and that's what the Fed wants is to bring that job opening rate down, but without nudging the unemployment rate higher.

Cris deRitis:                       Yeah. How many of those openings do you think are real?

Mark Zandi:                      Yeah. Right.

Ryan Sweet:                      That's a whole nother podcast.

Mark Zandi:                      Yeah. Right.

Ryan Sweet:                      Important one.

Mark Zandi:                      Yeah. I mean, we've got 10 million plus job openings. For context, before the pandemic, when the labor market was really tight, I think it was 7, 7.5 Million. So we're at 10. The peak was 11 million plus, so we're coming down, but we're still very elevated and that doesn't give you a lot of confidence that wage growth is going to start to moderate here and get back to that 3.5%. Except for what you just alluded to and that is, do you really believe it's a hard 10 million job openings?

Ryan Sweet:                      Right.

Mark Zandi:                      I would suspect companies, once they put up a job posting, are going to be pretty reluctant to take it down. What they do is they just slow boat any hiring. You say, "Okay, let's keep the interview process going, sort of tell the candidate to come in a month from now. We'll take our time and maybe we'll offer them something next year on the other side of whatever's happening now," that kind of thing. So I think we've got to come up with a term. I think I call them soft openings as opposed to hard job openings. That was the case a few months ago. But there's no way of, is there any good way of gauging that? I don't think so. I can't think of a good way. How real are those job openings?

Ryan Sweet:                      Right.

Mark Zandi:                      Yeah, exactly. Okay. But that's a good one though. We probably should watch that too. So the JOLT survey, Job Opening Labor Turnover survey, which has the job openings data, the quits rate, layoffs, that would be good to watch. Okay.

Ryan Sweet:                      Or Cris's favorite, jobless claims.

Mark Zandi:                      And jobless claims, yeah. A window into layoffs, which again, don't show any real meaningful erosion, at least not yet. Okay. What about, I say this with some trepidation, productivity growth? I mean obviously, as I said, 3.5% is the bogey that assumes 1.5% productivity growth. We certainly, if you believe the data, aren't getting that now. I mean, productivity is declining at least over last year. Should we pay any attention to that or is that just the measurement issues that are just too much to really use that measure in the near term? It's a bit of a lagged measure.

Ryan Sweet:                      I'm skeptical.

Mark Zandi:                      Oh, what's that? You're skeptical?

Ryan Sweet:                      I was just going to say I'm skeptical, because productivity is volatile, very volatile from quarter to quarter, even year to year. So if we're trying to assess stagflation risk in the near term, in the next 12, 18 months, I'd put productivity pretty low on my list.

Mark Zandi:                      Right. Okay. Yeah, I kind of agree with you. I mean, if it was a more accurate measure of reality, maybe.

Ryan Sweet:                      Right.

Mark Zandi:                      But doesn't feel like it. Okay. Any other indicators you would point to that might be helpful here? Ryan, anything in the financial markets that you think would be useful?

Ryan Sweet:                      I mean, of course oil prices. Different commodity prices.

Mark Zandi:                      Yeah, going back to the shocks.

Ryan Sweet:                      Yeah.

Mark Zandi:                      Yeah. That's a great point though. You're right. I mean, a lot depends on what's happening with these supply shocks, right?

Ryan Sweet:                      Correct.

Mark Zandi:                      Yeah. I mean, if oil prices are rising, that means much more likely, stagflation will become a problem. If the oil prices are falling or down, not so much or less so, and that's encouraging.

Ryan Sweet:                      And then getting back to another one of Cris's causes, I mean you could look at the market implied path of the Fed funds rate.

Mark Zandi:                      Yeah.

Ryan Sweet:                      So if that starts to really deviate from what the Fed is saying, then... I mean, right now they're anticipating the Fed cutting rates in late 2023. So basically, they're saying the Fed's going to contain inflation, then realize they did too much and then start normalizing and returning the Fed funds rate to its equilibrium rate.

Mark Zandi:                      Yep. Okay. All right. Well, let's wrap this up then like we typically do so that we make this more concrete. Let me ask you this. What do you think the odds are of a stagflation scenario developing over the next 12 to 18 months? And when I say that, a minimum viable stagflation scenario by my definition, unemployment being a percentage point above full employment, at least 4.5%, probably closer to 5%, and inflation one point above the Fed's target on CPI, so let's say 3.5%, maybe closer to 4%. In that we have this in a persistent way. It feels like it's going to remain in place throughout most of this period through 2023, the next 12 to 18 months. That's the stagflation scenario that I would say would be the minimum criteria for being labeled a stagflation scenario. So what's the probability of that happening over the next 12 to 18 months? Cris, you want to go first?

Cris deRitis:                       Sure. So for the US, who we're talking about here.

Mark Zandi:                      The US, and then we can do Europe or UK or whatever.

Cris deRitis:                       Next, yeah. I would say 10%. 10% for minimum viable.

Mark Zandi:                      Yeah.

Ryan Sweet:                      Yeah.

Mark Zandi:                      That's not that high.

Cris deRitis:                       It's not that high. For me, I view the distribution as a bit more barbelled, if you will. Either the Fed is going to be really aggressive and just will go right into recession, bring inflation down with it as an option, or not. We'll skate by. I don't know that we would have the conditions for stagflation scenario building up. The Fed kind of easing back and incisive. I just don't put a lot of probability weight on that scenario arising.

Mark Zandi:                      Yeah. Okay. And Ryan, what probability would you put on that scenario?

Ryan Sweet:                      Yeah, I would be close to Cris. 10%, 15% because I think the Fed's going to kill inflation.

Mark Zandi:                      Right. But by the way, can I ask, in that scenario, do we ultimately end up in recession?

Ryan Sweet:                      Yes.

Cris deRitis:                       Yes.

Mark Zandi:                      Yeah, yeah. Okay. Is that another feature of stagflation scenario that you ultimately end up in recession? Probably, right?

Ryan Sweet:                      Yeah.

Cris deRitis:                       Yeah. I've always thought of it as recession plus. All right.

Mark Zandi:                      Oh, is it? Well, oh, you're saying you have to be in recession to get unemployment up that high?

Cris deRitis:                       Yeah.

Mark Zandi:                      Not necessarily though. Oh, you think? Oh, maybe.

Cris deRitis:                       Well, okay. Then goes back to the gray zone.

Mark Zandi:                      Yeah, interest. Interesting.

Cris deRitis:                       Stagflation area.

Mark Zandi:                      Yeah. Yeah. If I go up a point on unemployment, that feels like a recession.

Ryan Sweet:                      That's a recession.

Mark Zandi:                      Right.

Ryan Sweet:                      Well remember, there's never been a recession where unemployment rate goes up by 30, 40 basis points on a three month moving average basis.

Mark Zandi:                      Yeah.

Ryan Sweet:                      You get one point, even if you spread it out over several months.

Mark Zandi:                      Yeah.

Ryan Sweet:                      That's a recession.

Cris deRitis:                       Yeah.

Mark Zandi:                      Yeah. I guess in a stagflation scenario, the recession happens later rather than sooner.

Ryan Sweet:                      Yes, right.

Mark Zandi:                      To allow the inflation to develop and become more persistent.

Ryan Sweet:                      Right.

Mark Zandi:                      So it's not your typical recession, if there's such a thing. In the current context, that would be you go into recession fast. The Fed pushes us in fast to wring out the inflation, whereas stagflation scenarios, they don't do that and we kind of hang in this tough world of recession, but still very high inflation for a while. And then the Fed says, "Enough already. I've got to wring this out," and they push us into recession. It just happens later. Okay.

Ryan Sweet:                      What are your odds?

Mark Zandi:                      About the same.

Ryan Sweet:                      Right.

Mark Zandi:                      Yeah. I wouldn't argue. I might even put it a little lower. Cris said 10%, you said 10% to 15%. I'd say 5% to 10%. Something like that. I think the probabilities are pretty low.

Ryan Sweet:                      So the fact that we all agree on something means we're going to have stagflation.

Mark Zandi:                      No, I know.

Ryan Sweet:                      That's never good.

Mark Zandi:                      Well, the only reason I get to 5% to 10% is only to the point you made that the supply shock could reverse, it could get worse again.

Ryan Sweet:                      Yeah.

Mark Zandi:                      I mean, who's to say the pandemic doesn't come back around, or who's to say something doesn't happen in oil markets or in the refinery industry that causes oil or gas prices to go skyward again? So given that, there is some meaningful, if I say 5% to 10% is meaningful. But I don't think the odds of a mistake, a policy mistake, they're pretty close to nil. I just don't see that happening. Yeah. I mean, the Fed is on the war path here. Anytime inflation expectations look like they're coming untethered, they're going to step on the brakes.

Ryan Sweet:                      You mean a policy mistake to cause stagflation?

Mark Zandi:                      Well, remember...

Ryan Sweet:                      It's still a policy mistake.

Mark Zandi:                      Yeah. Policy mistakes could cause it.

Ryan Sweet:                      Yeah.

Mark Zandi:                      I mean, this goes back to the causes of stagflation. It's the supply shock, it's the policy error and it's the structural issues. I'm saying the structural issues are much less relevant unless there's something I'm missing. I just don't see it. I mean, there are structural forces that might result in higher rates of inflation than we're anticipating like the backtracking on globalization for example. The increase in globalization in the last decade really weighed on inflation. Now, we're backtracking for lots of obvious reasons.

Ryan Sweet:                      Right.

Mark Zandi:                      So maybe there are some structural things that I'm discounting, but I tend to think they're small. The thing that gets me to 5% to 10% is the shock. That the shock can come back around and it's not on the policy side, I think. I think, but anyway.

Cris deRitis:                       What do you think for Europe or Japan?

Mark Zandi:                      Oh yeah, great point. Well, can we make a distinction between UK and the rest of Europe?

Cris deRitis:                       Yeah.

Mark Zandi:                      The Eurozone. I say UK...

Cris deRitis:                       I think they do.

Mark Zandi:                      What do you say on UK, Cris? What's that?

Cris deRitis:                       I think they do.

Mark Zandi:                      Oh yeah, they do. Yeah. Can we do that please? Yeah, exactly. Okay. What do you say on the UK and then on the Eurozone? This is to Cris.

Cris deRitis:                       Oh. Substantially higher.

Mark Zandi:                      Yeah.

Cris deRitis:                       I'm trying to think where I would go.

Mark Zandi:                      Yeah.

Cris deRitis:                       I'd put it higher in the UK probably than the Eurozone.

Mark Zandi:                      Yeah.

Cris deRitis:                       And pretty high.

Mark Zandi:                      Over 20%?

Cris deRitis:                       They're all at 30%, 40%.

Mark Zandi:                      Oh, wow. That is high.

Cris deRitis:                       Because I do think that they're much more vulnerable to the shocks, another shock.

Ryan Sweet:                      Yes.

Mark Zandi:                      Okay. You too, Ryan?

Ryan Sweet:                      Yeah.

Mark Zandi:                      30% to 40%?

Ryan Sweet:                      30% to 40%. Yeah.

Mark Zandi:                      Yeah. No, I'm not that high. I'm closer to 20%, maybe 25 if you pressed me. And then on the Eurozone...

Cris deRitis:                       But you came in at 10% until you heard the 30%, right?

Ryan Sweet:                      Yeah.

Mark Zandi:                      No, no, no, no, no. I wasn't at 10%. I might have gone up from 15% to 20%. I don't know. Subconsciously...

Cris deRitis:                       How about anchoring?

Mark Zandi:                      Yeah. That's not anchoring. You're pulling me northward. On the Eurozone, I say that's higher than the US, but lower than UK, so I'd say 10% to 15%. So 5% to 10% for the US, 10% to 15% for the Eurozone, say 20%-ish for the UK. Something like that. Yeah. All right.

Cris deRitis:                       What about a Japan? I've heard people trying to figure that one out.

Ryan Sweet:                      But Japan has inflation.

Mark Zandi:                      Yeah.

Cris deRitis:                       What does that even mean? It's tough to...

Mark Zandi:                      Well, their target is 2%, and they just barely got above 2% with all of this mess.

Cris deRitis:                       Yeah. I think they're like 2%.

Mark Zandi:                      No, I'm not worried about them.

Cris deRitis:                       2.3%, 2.4%.

Mark Zandi:                      Yeah. I think it's still a deflation worry and not a stagflation worry.

Cris deRitis:                       Right.

Mark Zandi:                      Okay. Anything else on this topic that we think is important that we missed? I think we covered a lot of ground. I think we feel pretty good about it. Okay, last call. Anything else on stagflation? All right, very good. I think we're going to call this a podcast and listener, if we did miss something, I just have this nagging feeling that there's something we missed that was big, but I can't think of what it is. Let us know and we'll come back around and address that. So with that, thank you very much and we'll talk to you soon. Take care now. Oh, by the way, this is what I forgot to say. We run these scenarios across different countries all over the world, US, UK, Europe. Not just the baseline scenario where everything works out, not just a typical recession where we suffer a downturn consistent with the average recession since World War II, but we also run stagflation scenarios. So if you're interested, let us know and we can help you with that. So now, for real, thank you for listening in. Talk to you next week.