Stagflation-lite

The US economy is in a strange place right now. Growth is slowing while inflation rises, a combination that could, at least in theory, lead to stagflation. That’s actually hard to pull off in normal times; usually, it’s an overheating economy that nurtures inflation. In fact, until the 1970s, stagflation was thought to be practically impossible, and since then it has been rare. The degree of each factor makes the difference. In our view, they haven’t hit alarming levels yet, but it is helpful to frame the situation with that term. Let’s call it stagflation-lite.

Although GDP growth was a better-than-expected 3% in the second quarter, the economy seems to be slowing beneath the surface, something we expect to continue for at least the balance of the year. GDP numbers in the first couple quarters of 2025 have been choppy, mostly due to trade and inventories. Despite the rebound in Q2, the contribution from private domestic final sales (a measure of core demand) declined to roughly one percentage point, versus about 2.5% in 2024, highlighting softening underlying activity. Also, the ISM and S&P Global PMIs are cooling, signaling slowing across sectors.

Effective tariff rates stayed “only” near 10% through June due to inventory front-loading and trade diversion—but that number is trending higher following this summer’s trade deals, meaning that more cost pass-throughs lie ahead. Tariff-related disruptions could potentially shave 1% off GDP (a big tax on consumers), while also putting upward pressure on inflation. Core PCE inflation is 2.8% and projected to rise further before gradually cooling toward the Fed’s 2% target. Again, not quite stagflation.

On the jobs front, firms seem to be hiring fewer workers but aren’t laying off their current workforce aggressively. That’s a major reason why we are not uttering the word “recession.” Despite sharp downward payroll revisions, the unemployment rate has stayed within a range of 4.1–4.2% for six months. This suggests that the breakeven pace of job gains has dropped, potentially due to immigration constraints and an aging population. Tax cuts and deregulation will likely help, and it’s also possible that the federal government might send some of the tariff income to consumers, maybe through rebate checks.

Furthermore, the Federal Reserve is likely to cut rates next month, which should offer encouragement to employers and consumers alike. The market has largely priced in a September cut but is still looking for clues from Chair Powell's Jackson Hole speech on Friday. Frankly, given the slowdown in the economy, it would be a policy error for policymakers to leave rates unchanged at their next meeting in September.

In light of the above, we expect the Treasury yield curve to steepen; usually that happens before the Fed cuts. Credit spreads are much lower than the historical average, which makes investment-grade and high-yield bonds less attractive. Trade finance has been appealing, given its historically low correlations with other asset classes and attractive current yields. TIPS may also benefit from the elevated real yields.

Eventually, stagflation-lite will give way, either because inflation soars or because economic growth returns. Full-blown stagflation is rare and likely to stay that way.