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Mike Miranda:
Welcome to Beyond the Portfolio. I'm Mike Miranda, Head of Investments for BMO Private Wealth North America. In each episode, we'll bring you expert analysis from BMO's top strategists and economists to help you navigate market conditions and stay informed. We're recording this episode on Monday, August 11, and today we're tackling a topic that has re-emerged in the economic conversation, stagflation. It's a word that brings to mind the 1970s when the unusual combination of high inflation and stagnant growth created one of the most challenging environments for policymakers, businesses, and investors alike. Today, there's debate over whether we could be headed for something similar.
On one hand, growth has shown signs of slowing from last year's pace. On the other, inflation, while well off its peak, remains above the Fed's target. That tension between growth and inflation is at the heart of the stagflation debate. Coupled with that are the fiscal policy shifts that have begun to materialize in the U.S. So is stagflation a ghost from the past or a storm on the horizon? To help us sort through the risks, what we've actually seen so far and how policymakers might react, I'm joined by Doug Porter, Chief Economist at BMO. We'll explore whether stagflation is a real risk or just a market scare, what our base case looks like for growth and inflation, which way surprises are more likely to break, and how the Fed's bias might tilt as the year unfolds. Doug, it's great to have you with us.
Doug Porter:
Well, thanks for having me.
Mike Miranda:
So Doug, stagflation has been a buzzword lately, higher inflation coupled with slowing growth. From your perspective, how real is the risk of stagflation in the U.S. and Canada right now, and how does it compare to the historical episodes like the 1970s?
Doug Porter:
Well, Mike, I'm glad you referenced the 1970s because to me, that's what real stagflation looked like. We had episodes where the inflation and the unemployment rate were both in the double digits, and of course, we're just not in that league. So I think it's a very overused word, but it is fair to say that we are seeing a little bit of upward pressure on both the unemployment rates and the inflation rates at the same time, which is a bit unusual. Typically, economists tend to believe that if unemployment is rising, that that will reduce pressures on inflation. So it is a little bit rare to get the so-called supply side shock where you get a little bit of a bump up in both. For instance, if we look at the consensus on the U.S. economy a year ago, regarding where we'd be now, what we've seen is the consensus is both somewhat shaved its growth outlook, somewhat pushed up the unemployment rate, and also somewhat pushed up the inflation rate.
But it's really not what I would call stagflation. And why are we doing this though? Why have we seen a little bit of upward pressure on both the unemployment rate and inflation? It's largely because, frankly, of the trade war. It does act as a minor supply shock. When we saw the really bad stagflations of the seventies, we had the so-called mother of all supply side shocks in terms of a double barrel dose of huge increases in oil prices, which did come as a big shock at that time, and it led to both higher inflation and higher unemployment. This is definitely what I would call stagflation-light, what we've seen in the past year. So just to wrap it up, I would say it's a somewhat overused term, but we have seen a little bit of the unfortunate combination of both higher unemployment and higher inflation.
Mike Miranda:
Yeah, that's helpful, Doug, and I appreciate the way you frame that. So if you look at the data right now, I guess on the GDP side and inflation, what trends are you seeing so far this year? Are we closer to a soft landing, a slowdown, or something more like that stagflation-light scenario that you outlined?
Doug Porter:
Well, we had a lot of noise in the first half of the year, and largely it was because of front running ahead of the tariffs. So we had this very unusual decline in GDP in the first quarter and then a big bounce back in the second quarter. I think it's probably fair to take an average of the two, or maybe a better way to do it is take out the noise that we saw in inventories and net exports, so really look at just final domestic demand. In other words, what's actually spent in the U.S. economy, what's produced there, and what we saw was growth in the mid to low 1%. I think that's a fair portrayal of how the U.S. economy really did fare in the first half of the year. It's definitely a cool down from what we saw in 2024. I wouldn't quite call it a soft landing yet because frankly, we have definitely not seen the full impact of tariffs.
I mean, we're still getting news on the tariff front pretty much every day, and I do think corporations have gone out of their way to not pass them fully along, at least not yet. I think eventually most of it will get passed on or quite a large proportion, and that's going to put a little bit more further upward pressure on inflation as we go through the rest of this year and in the next year. And I think it will chip away a bit at growth. But up to this point, what I would say is it's consistent with a slowdown but not what I would call stagflation.
Mike Miranda:
All right, thanks for that, Doug. So, let's think about the policy implications then, because I know that's important certainly for the markets. We've talked about what growth and inflation are telling us right now and how it maybe doesn't really stack up hugely against that stagflation risk. On the policy side, how central banks respond could be just as important as that economic data. So what's your read on the Fed's reaction function at this stage? Obviously they have this dual mandate both on the growth side and inflation. Is there bias more towards fighting inflation or supporting growth? And how might that play out over the next six to 12 months?
Doug Porter:
So I actually think their reaction function's a little bit different than it might've been, say six years ago before the pandemic. I think they are a bit more concerned about inflation. They do not want to make the same mistake two times within three years of letting inflation run on them. But I do think, you ask where's their bias right now? Well, I think it's shifting as we speak. I do think the heavy duty revisions to the employment numbers and the relatively soft number we saw for July, it does sort of change the picture for the Fed. Provided we have decent inflation numbers over the next month, I think the table is set for a September cut. We already had a couple Fed governors leaning in that direction even before they saw that disappointing July employment report. I think provided inflation doesn't really flare up in the next month, we are going to start seeing the Fed begin to cut again.
The reason why they've been very cautious this year, frankly, I think it's got nothing to do with politics. I think it is because they were truly uncertain about how inflation would respond to the rise in tariffs. And to me, so far the news has been relatively good on that front. We've seen a small bump up in inflation, but I think for most economists, the surprise has been how little inflation we've seen so far from the tariffs. I don't think it's going to completely stay that way.
I believe we will see some upward pressure on inflation, but I don't think it'll be meaningful enough to keep the Fed from easing. And then the other side of their mandate, as you said, the employment side, we have had pretty clear signs that things are slowing. The unemployment rate is starting to tick up. It's at 4.2. It's not particularly worrisome, but I do think the direction of travel here is fairly clear that the unemployment rate is likely to drift a little bit higher over the next six months. And between that, and still calm inflation, I think does set the stage for the Fed to start cutting.
Mike Miranda:
Well, that's helpful, Doug, and it's helpful to hear where you think the forecast is for the next few quarters. Maybe let's just probe one last question on that forecast. Obviously no outlook is set in stone and the economy does certainly have a way of surprising us often when we least expect it. If our base case turns out to be wrong, where might the surprises materialize? Is it on the growth side either to the upside or the downside? Is it on the inflation either to the upside or the downside? I know we've talked about this before, there's kind of four potentials here. You could either have stronger growth and persistent inflation, you could have weaker growth and some sharper disinflation. We could have a meaningful stagflationary environment, which is I guess what the market fears, weaker growth in higher inflation. Or conversely, optimistically we could have a resumption to the stronger growth and the disinflation that we experienced over the last year. So that's kind of the four paths that it could evolve. If we're wrong there, Doug, where do you see that going potentially?
Doug Porter:
Yeah, and just to quickly level set in terms of where we and the consensus are, and frankly, our forecast is very close to consensus. That's more by accident than design. But the overall consensus is assuming that economic growth will be about 1.5% or so this year and next, and it's assuming that headline CPI inflation will be just a wee bit below 3% this year and next, so just in terms of where the consensus sits right now, I would say probably the risks on the growth side are to the high side. I think if we're going to be surprised, it's that growth is actually going to outperform. The economy so far has proved to be fairly resilient to the tariffs. I'm not saying it's completely escaped damage on that front, but I would say growth has held up relatively well amid all the uncertainty, and we now have some certainty or some clarity on the trade front.
We certainly have clarity on the fiscal side. So I believe that if there's going to be a surprising growth, it's going to be due to the high side. Now, on the inflation front, that one's a little bit more of a difficult call for me. I would tend to say the same thing. In other words, if we're going to be a little bit surprised, it's that there's going to be a bit more pass through from the tariffs and we'll get a somewhat higher inflation. But I have to tell you, I'm not overly concerned because in the last 50 years, it's been incredibly rare to have inflation seriously surprised to the high side when energy prices have been calm or falling, and that's where we're at right now, certainly with oil prices and to a lesser extent, natural gas prices.
They're really not doing that much, and oil prices are, if anything, drifting lower. So while I do think there's some upside risk on core inflation, I'm not overly concerned that it's really going to break out and lead to a serious inflation issue, not with oil prices holding at around $65 a barrel or so. So in terms of your four options, I guess I would slightly lean to, if we're going to be wrong, it's that growth, and to a lesser extent, inflation will be a little bit higher than what we and the consensus believe. I think that's the way the risks lie at this point.
Mike Miranda:
Doug, thanks for walking us through the data, the risks and the policy outlook. Stagflation is one of those economic scenarios that can unsettle both the markets and investors, not only because of the challenges it presents, but because it forces difficult trade-offs for central banks. and policymakers. I really appreciate your perspective on the manageable nature of this risk right now. Whether we end up with a soft landing, a more pronounced slowdown, or a stubborn inflation problem, understanding the dynamics between growth, inflation and policy is key to making informed investment decisions for our clients. As always, the economy doesn't move in straight lines, and the biggest risks are often the ones that catch us by surprise. That's why these conversations matter. They give us a framework for thinking through different outcomes and preparing for them.
For our listeners, thanks for joining us on this episode of Beyond the Portfolio. We'll continue to bring you timely, relevant insights from across BMO's investment and economic teams, as well as broader insight partners so you can stay ahead of the curve.
Thank you for listening to Beyond the Portfolio. You can follow us on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Mike Miranda.
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