The Coming Stagflation Bust

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Stagflation will be when inflation runs high while demand for goods and services falls and the economy declines.

The US has been importing deflation due to both outsourcing our manufacturing base as well as a surging US dollar since 2011.

The triple-whammy set-up may be coming that would likely give us stagflation.

Over the summer, former Fed Chair Alan Greenspan suggested in a Bloomberg interview:

"What I'm concerned about mostly is stagflation, meaning I think we're seeing the very early signs of inflation beginning finally to pick up as the issue of deflation fades," Greenspan, 90, said. "We're just in a stagnation state."

Read more: Greenspan "Nervous" Bond Prices Too High, Sees Stagflation Ahead

Greenspan's arguments for stagflation, from what I read, range from there being too little capital investment that has resulted in too little gains in productivity to too much money being spent on government entitlements.

It is very true US productivity is nearly dead in the water for the last five-plus years now:

For the most part, I agree with Mr. Greenspan.

To better grasp this concept, we need to understand the factors that impact and create inflation and deflation in the first place. I'll explain below.

Three Faces of Inflation and Deflation

1. Credit Growth

The biggest influence of how much goods and services your paycheck will buy in the following year is based on how much credit was created in that year on a per-capita basis.

Debt and loans are what make up the total credit in the US economy. When we put these two figures together, it equates to $64.827 trillion as of June 30, 2016.

Now, I will show you why credit creation per capita plays such a big role in the rate of inflation.

The following graph shows the year-over-year percent change in credit creation per capita vs. the inflation rate.

Credit creation, the blue line, generally runs higher than the inflation rate. That's a result in gains in productivity allowing for more goods and services to be had while prices remain stable.

2. Productivity

In other words, inflation is kept down on account of gains in productivity. If I were to add the gains in productivity back into the rate of inflation, it would look like this:

3. Currency

The one anomaly in this chart is the spread that occurred during the 1980s. Credit growth soared and inflation remained very low.

A good deal of this spread came from a surging US dollar, allowing Americans to buy foreign goods cheaply and in essence, import deflation.

Getting a handle on these three factors is what will give us the best chances of seeing where we are headed, inflation or deflation-wise.

The Triple Whammy

The stagflation set back would be caused on account of these three things occurring together:

1. Higher rates of aggregate credit growth.

Per capita credit growth is actually rising for the past three quarters and is now growing at an annual rate of 3.2% year over year as of June 30th, 2016. Government and the millennial generation will likely be the biggest drivers of new credit creation.

2. Little to no productivity growth.

There is little to suggest any rebound in productivity in the US economy. Without productivity, there is no offset to the monetary inflation.

3. A declining US dollar.

If we were to see the US dollar weaken, then instead of importing deflation, we would instead be importing inflation. What we've been receiving since roughly 2011 is a surging dollar. A boom in credit growth may well result in a weaker US dollar.

If these three things were to happen at the same time, welcome to the world of stagflation. Higher costs, a declining economy and lower living standards.

Impact On Markets In Stagflation Scenario

  • Higher interest rates on bonds would certainly cause for lower-yielding, longer-dated bond prices to fall in value.
  • Stocks would likely head lower too as higher input costs would hit margins. Dividend-paying stocks also may fall to boost the dividend yields making them more competitive to bonds.
  • Gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) would very likely rise under a scenario of higher inflation that comes from account of higher credit growth and a weaker dollar.
  • Real estate is a little more tricky as it could prove to be a place to park money to hedge inflation, higher mortgage rate increases may impact affordability and thus keep a lid on prices too.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.