U.S. Economic Outlook

Is there a real risk of stagflation?

The word of the moment is “stagflation.” Not a day passes without “stagflation” in the headlines of major news outlets, TV shows and market commentary alike. But is stagflation a realistic threat, or not?

Mainstream economics interprets stagflation as a situation in which economic growth is below its potential while inflation remains elevated. It’s the persistent inflation that is the most troubling aspect of the problem. Normally, in economic business cycle theory, lower growth rates imply lower demand, which in turn keeps prices in check. Stagflation therefore implies an abnormal condition, something outside the normal way in which the economy is expected to work. An external shock to the supply side, such as sharply rising energy prices, might be the cause of a stagflationary episode. Real growth rates could decline quickly as the supply side either passes on the increased prices or limits its output (including by reducing its staff numbers) while households’ budgets, diminished in real terms by the price shock and the potential loss of income, constrain demand. The consequence of such a situation is that neither supportive fiscal nor monetary policy can prevent a recession. In fact, both fiscal and monetary measures as a response to the crisis might make things even worse. Accommodative monetary policy would further support higher prices and expansive fiscal policy would stimulate demand, which again might fuel inflation. The only way forward is to fight inflation aggressively by quickly rising rates.

The 1970s are seen as the prime example of the damage stagflation can do. A series of supply shocks hit an already stumbling U.S. economy. Shortly after the “Nixon shock” in 1971 (a series of far-reaching economic policy decisions), surging oil prices caused by OPEC’s oil embargo in 1973 and the Iranian Revolution in 1979 sent the economy into a series of recessions with extremely high inflation rates.[1] The dilemma with high inflation was only solved years later into the 1980s when the then Fed Chair Paul Volcker aggressively increased interest rates to now unimaginable levels of around 20%.

Today we think the situation is a little different and do not see the economy as being on a direct path to stagflation. The pandemic has indeed been a major external shock to the economy but one that has mainly affected the demand side. Stay at home rules and other measures to fight the pandemic suppressed household demand in an unprecedented way. Policy-makers reacted swiftly with a combination of massive fiscal and monetary measures. The result of this stimulus is that the downturn was the shortest and sharpest in history. Fiscal measures stimulated growth rates way beyond what can be considered the normal potential growth. Chart 1, which compares the so-called output gap[2] with inflation, illustrates this.

Chart 1: Output gap vs. Inflation

202110_U.S. Economic Outlook_Chart_1.png

Sources: Bureau of Labor Statistics, Bureau of Economic Analysis, Congressional Budget Office, Haver Analytics, DWS Investment GmbH as of 10/15/21

Industries like the durable goods sector suddenly faced demand way above pre-pandemic levels which, combined with pandemic-related frictions in global trade and transportation, might eventually lead to higher prices for such goods. Meanwhile the pandemic may also have acted as a broader external shock to the supply side. Producers in certain industries – mainly in contact-intensive industries like leisure & hospitality – cut back capacity, materially lowering supply.

As time has proceeded the discovery of vaccines has provided a realistic route out of the pandemic. Social distancing and stay at home orders have been lifted and slowly consumers have again felt confident enough to engage in activities that were either unappealing or even impossible during the worst months of the pandemic. This process of normalization has induced the beginning of a shift back in consumption to pre-pandemic spending patterns (see Chart 2).

Chart 2: Material change of consumption patterns.

202110_U.S. Economic Outlook_Chart_2.png

Sources: Bureau of Economic Analysis, Haver Analytics, DWS Investment GmbH as of 10/15/21

The increased demand for services now faces the problem of substantially lower capacity, as businesses went bankrupt and/or workers have moved to other areas or remain reluctant or unable to work, while at the same time the goods industry continues to struggle to keep up with increased demand. The consequence of these supply and demand imbalances is increasing prices.

Looking ahead, the key question is how these imbalances will be resolved. The main uncertainties remain on the supply side. Without a doubt it will take longer for the supply side to build back the capacity needed than most analysts have expected. Until this adjustment process is complete resilience on the demand side may be enough to prevent the economy from slipping into a stagflation scenario. If demand remains robust enough to keep growth above its potential, the economy will not, by definition, be stagnating; the problem that will remain will be simply inflation. But the clock is ticking on the growth front as well. The demand side of the economy probably passed the point of peak consumption in the 2nd quarter of 2021. Fading government support, higher prices, the remaining drag from the pandemic and the ebbing away of excess savings (Chart 3) now mean that growth might slow in coming quarters.

Chart 3: Still some excess savings left.

202110_U.S. Economic Outlook_Chart_3.png

Sources: Bureau of Economic Analysis, Haver Analytics, DWS Investment GmbH as of 10/12/21

While slowing growth as fiscal support fades has been widely expected, uncertainty about how quickly growth is slowing is most likely at the root of all the stagflation fears. And higher prices could exacerbate the slowdown. A quick calculation reveals that every sustained increase in inflation of 1% reduces growth by approximately 0.1% in the short term. Given current inflation rates, and based on our forecasts, we do not expect growth to decline persistently below its potential rate before 2023. This should give the supply side enough time to adjust. But if another shock, such as, for example, an extended energy price crisis, happens or it turns out that supply chain rigidities persist even longer, the stagflation scenario may begin to be played out – but for now we believe this remains a risk case.

Overview: key economic indicators

















GDP (% qoq, annualized)









Core inflation (% yoy)*










Headline inflation (% yoy)*









Unemployment rate (%) (EOP)









Fiscal balance (% of GDP) (EOP)









Federal funds rate (%)









 *PCE Price Index
** Forecast

Source: DWS Investment GmbH as of 8/10/21
Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect.


1. The so called “Nixon shock”: In 1971 President Nixon unleashed a series of economic policies to counteract the negative fallout from increasing global competition. Among them was the suspension of dollar convertibility into gold (therefore the breakdown of the Bretton Woods System) and the introduction of wage and price controls. A major consequence of these policies, fueled by substantial monetary and fiscal support, was depreciation of the dollar that induced an inflationary shock once price and wage controls were lifted again in 1973.

2. The output gap is the relative difference of the current level of GDP compared to its potential.


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