Stagflation Or Worse Ahead

Scott Anderson
Chief Economist
Bank of the West

We were bracing for a bad inflation report for May, but the headline and core CPI inflation measures both outdistanced our projections and accelerated sharply from April's pace.

Consumers Have No Place Hide From Rising Prices

Price increases last month were led by energy (+58.4% annualized pace), transportation (+26.8% annualized), and food and beverage categories (+14.5% annualized). Notable price increases were also recorded for housing (+10.7 annualized) and services (+9.4% annualized) There was really no place for consumers' to hide from rising prices last month with most categories of spending rising at a 4.5% annualized pace or better.

In short, there was virtually no good news in today's CPI report, increasing pressure on the Fed and Administration to do much more to change the price trajectory. Today's report prompted another upward revision in our near-term inflation forecasts and will likely push the Fed toward an even more hawkish rate hike path this year. We now expect three 50 basis point rate hikes at the next three FOMC meeting starting next week (June, July, and September). The Fed funds target rate is expected to be between 2.75 and 3.00 by year-end and rise to 3.25-3.50 by mid-2023.

These adjustments to the economic outlook raise the odds of a stagflationary outcome or worse for the U.S. economy over the next six quarters. We put the odds of a U.S. recession about a year from now somewhere in the 40-50 percent range. Not yet our baseline forecast, but getting dangerously close to it.

Consumer inflation is forecast to peak this quarter at 8.3% from a year ago on a seasonally adjusted basis, slowing to only 7.5% by the fourth quarter of this year, before declining more meaningfully in 2023 to around 3.2% by the fourth quarter of next year. This historically high level of inflation is likely to be sustained for a while even as consumer spending and GDP growth continue to slow. This is the very definition of stagflation (stagnation with inflation). This is a miserable economic condition that most workers today have never seen before. One has to go back to the oil embargo days of the 1970's to see a similar economic environment.

Stubbornly High And Persistent Inflation Forecast

In fact, stagflation is such a miserable economic condition economists invented the Misery Index to help describe the economic pain that is felt by the average consumer. The Misery Index is just the sum of the inflation rate and unemployment rate. Today this measure is around 12.1%, levels last seen coming out of the Great Recession and the 1990-91 recession.

The plunge in the University of Michigan Consumer Sentiment index to a record low in June is a telling indicator of consumers' sour moods and downbeat expectations for their economic and financial future.

Consumer Sentiment Hits A Record Low in June

We acknowledge that the current high inflation and rising gas prices are the primary driver of the plunge, but if this decline in confidence is sustained it will become a bigger driver of consumer spending behavior. For now, trillions of dollars in excess personal savings and pent-up demand for services like travel and tourism are allowing consumers to close their eyes and keep spending despite rapidly rising food, energy and rent prices. But a day of reckoning may be coming if supply and demand don't rebalance soon and the Fed fails to bring down price inflation to a more sustainable level.

To learn more, check out this week's U.S. Outlook Report.

Contributors

[Contributors Section]