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The stagflation debt crisis and a narrowing path for monetary policy

Updated: Sep 25, 2023


Nothing contained in the following content constitutes an offer, solicitation, or recommendation regarding any investment management product or service, or the offer to sell or the solicitation of an offer to buy any security; The following content is purely for information only and is based on information available at the time it was created. It does not take your financial situation or goals into consideration, and may not be suited for you.

Federal reserve has never pulled off any soft-landing, with inflation surpassing 5% since WWII. However, global inflation is exceeding 8%, with central banks worldwide stepping hardest on the gas break. Is a "softish" landing achievable? Can the fed balance the tipping point between unemployment and inflation risks?

The nature and sustainability of the current inflation

Inflation has proved non-transitory from the data we have consistently seen in the past year. The increase in inflation is fundamentally driven mainly by supply-side shocks rather than excessive aggregate demand created by expansionary monetary policy, credit market injection, and fiscal policies. The initial COVID lockdowns, supply chain bottlenecks, a reduced US labor supply, deglobalization, meta-narrative of dichotomy, the impact of Ukraine's war on commodity prices, and China's zero COVID policy continue to pose challenges to the global economy.

Eurozone, the UK, China, and the United States will continue to experience higher inflation levels if those fundamental reasons causing inflation remain intact. Suppose we retrospect how everything started from geopolitical, international relations, and diplomatic perspectives, we will find that the likelihood of supply shock being resolved soon is pessimistic though we have seen some of the bottleneck ease.

Though a large group of economists and many recognized this beforehand, it is now finally acknowledged by Fed publically that supply considerations have played a progressively more significant role in inflation.

This is significant because supply-driven inflation is a critical element in creating stagflationary, increasing the likelihood of a harsh landing and possibly higher unemployment and recession when monetary policy is tightened.

To what degree does monetary policy matter and what if Fed pivots

The concern is whether a harsh landing prophecy will weaken the central banks' inflation-hawkish commitment. The short answer is monetary policy has been effective in managing demand-side dynamics. Still, it is hard to balance the unemployment rate and inflation regarding supply-side shocks. There are inherent risks associated with monetary policy withdrawal, and inflation can be persistent if the response curve fades away. This has been supported by data in the context of monetary policy contraction in Russia, Turkey, the UK, and India in the past, making it even less likely for the Fed to pivot with current inflation ratings.

From what we currently stand, on the one side is a possibility of a relatively short-term recession that will ensure long-term prosperity in the lifespan of monetary history (like Volcker and Burns). On the other side, if it pivots, it is guaranteed to risk the response curve's fading and continued inflation. Most central banks are already behind the curve at the current stage. Therefore, the Fed will only pivot when something starts to crack in the economy. Reaching this stage, the pivots may not work as we have seen the correlation between rates and the rest of the economic variables break during each crisis and recession. As indicated in the 2022 October 5th EST Daily Memorandum, we have started to see an early sign of correlation fading on hour charts, while weekly and monthly charts reach the same level of high correlation during past recessions.

Therefore, even if Fed stops tightening policy once a hard landing becomes likely, we can anticipate a persistent rise in inflation and either economic overheating (above-target inflation and above-potential growth) or stagflation (above-target inflation and a recession), depending on whether demand shocks or supply shocks are dominant.

A stagflation debt crisis is looming

Numerous indications indicate that a catastrophic stagflationary debt crisis will define the next recession. Private and state debt levels are substantially higher today than in the past and have increased from 200% of world GDP in 1999 to 350% presently (with a particularly sharp increase since the start of the pandemic). Moreover, rapid normalization of monetary policy and increasing interest rates will force highly leveraged households, corporations, financial institutions, and governments into insolvency and default under the abovementioned conditions.

The subsequent crisis will differ from its predecessors. In the 1970s, there was stagflation, but there were no significant debt problems. After 2008, we saw a debt crisis followed by low inflation or deflation due to the negative demand shock caused by the credit crunch. Today, we are confronted with supply shocks in the setting of considerably larger debt levels, which suggests we are headed towards a combination of 1970s-style stagflation and 2008-style debt crises — a stagflationary debt crisis.

In response to stagflationary shocks, a central bank must tighten monetary policy even while the economy approaches a recession. Central banks were previously able to aggressively loosen monetary policy during the global financial crisis and the early months of the epidemic in response to weakening aggregate demand and deflationary pressure. This time, the budgetary expansion space will be more constrained. Most fiscal arsenals have been employed, and governmental debts are becoming unsustainable.

In addition, because today's increased inflation is a global phenomenon, most central banks are tightening simultaneously, increasing the likelihood of a synchronized global recession. This tightening is already having an effect: bubbles are bursting across the board, including in public and private equity, real estate, housing, meme stocks, cryptocurrency, SPACs (particular purpose acquisition companies), bonds, and credit instruments. As a result, real and monetary wealth is declining, while debts and debt-servicing ratios are increasing.

How many times Fed has pulled off the soft landing since WWII

This goes straight to the final question: Will the US Federal Reserve and other major central banks' tightening monetary policy result in a harsh or gentle landing? Most central banks and Wall Street occupied "Team Soft Landing" until recently. The consensus, however, has fast shifted, with Fed Chair Jerome Powell acknowledging that a recession is possible and that a smooth landing will be "very difficult."

In addition, a model employed by the New York Federal Reserve Bank indicates a high likelihood of a hard landing, and the Bank of England has echoed similar sentiments. Several large Wall Street banks now view a recession as their baseline case (the most likely outcome if all other variables are constant). Indicators of future economic activity and consumer confidence in the United States and Europe are falling precipitously.

It is much harder to achieve a soft landing under stagflationary negative supply shocks than when the economy is overheating because of excessive demand. Since World War II, there has never been a case where the Fed achieved a soft landing with inflation above 5% (currently above 8%) and unemployment below 5% (currently 3.7%). And suppose a hard landing is a baseline for the United States. In that case, it is even more likely in Europe, owing to the Russian energy shock, China’s slowdown, and the ECB falling even further behind the curve relative to the Fed.

How dreadful this recession could be

In ordinary mild recessions, the US and global equities tend to decline by approximately 35%. However, because what we are facing today might be stagflationary and preceded by a financial crisis, the probability of a fall in the equity markets could be closer to 50 percent.

Regardless of the recession's severity, historical evidence indicates that the stock market has a considerable distance to fall before reaching its bottom. In the current environment, any rebound should be viewed, at least from a cautionary perspective, as a dead-cat bounce instead of a buy-the-dip chance. Although the present global scenario poses numerous issues, there is no true enigma to solve. Things will worsen significantly before they improve.


  • Nelson, B., Pinter, G., & Theodoridis, K. (2015). Do contractionary monetary policy shocks expand shadow banking?

  • Cambazoğlu, B., & Karaalp, H. S. (2012). The effect of monetary policy shock on employment and output: The Case of Turkey. International Journal of Emerging Sciences, 2(1), 23-29.

  • Murgia, L. M. (2020). The effect of monetary policy shocks on macroeconomic variables: Evidence from the Eurozone. Economics Letters, 186, 108803.


Nothing contained in the proceeding content constitutes an offer, solicitation, or recommendation regarding any investment management product or service, or the offer to sell or the solicitation of an offer to buy any security; The above content is purely for information only and is based on information available at the time it was created. It does not take your financial situation or goals into consideration, and may not be suited for you.


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