Michael Bruno and Jeffery Sachs in the 1980's developed a generalized framework for stagflation that rests on two key conditions: (1) a large and unexpected increase in prices for inputs produced externally requiring a reduction in the standard of living for importing countries (a supply shock), and (2) wage inflexibility that reduces demand for labor and thereby increases unemployment. We do not currently fit the framework on both conditions, but we have an environment where markets are not clearing and causing a growth/inflation dislocation.
We have an unexpected increase in prices from an oil shock, goods congestion, and labor shortages. There is a clear supply shock caused by the pandemic that is causing a slow adjustment on the real economy that is not solved by fiscal policy supporting the demand side of the economy.
The labor market is not clearing at current prices. The number of jobs offered is greater than supply, labor participation is below expectations, and unemployment is low.
The pandemic effect on the economy is still a drag from fear, industry adjustments, and mandates requirements. The markets are now realizing that we are far from normal. This is not a demographic problem. It is a policy problem because the supply shocks were self-induced; however, it is not solvable through more expansionary fiscal and monetary policy.
The bottom-line "cyclical stagflation" be present at least through the first half of 2022 based on a slow adjustment scenario. There is no quick policy fixe being discussed. Earnings will start to see a negative impact as operating costs grow and risk assets will fall out of favor. Flows to safe assets will increase even with higher expected inflation.
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