Stagflation lite: What this means for the U.S. economy

Hello, and we're back on the to-minute take with an update on our US micro outlook on your host, Claire Fan. And I'm Carrie Freestone. It's been a little while since we've updated you on our US view, and we've had a slew of significant data surprises over the last few weeks from non-farm payroll employment revisions to a pretty massive upside-to-pride to the producer price index data. In this episode, we'll break down everything that's happened in the US micro data as of late, and what this means for our outlook going forward. And there's a little spoiler alert, I can tell you that if anything, we have even more conviction in our stagflation light view than we did before. What a great teaser. Let's get started. Okay, Carrie, you mentioned a stagflation light view, and that's where I want to start. Is the US economy in a stagflation right now? And how does this differ from instances we've seen before? So glad you asked. Okay, so stagflation light is basically the current theme underpinning our US macro viewpoint right now, and I actually just got asked this on a call the other day. How were we seeing this stagflation light scenario play out? So I will say that in general, stagflation is a phenomenon where prices are rising notably. So we have inflation at the same time that growth is slowing. And that could show up in weaker consumer spending, slowing business investment, and rising unemployment to name a few manifestations of slower growth. I think what a lot of people talk about stagflation, they think about the most extreme case of US stagflation, which is actually what we saw in the 70s during the OPEC embargo. We had oil prices skyrocket, which led to double digit inflation. And this also saw massive unemployment and growth outright declined. We don't expect to see stagflation on this level as a result of tariffs, hence the stagflation light characterization. But having said that, we do expect tariffs to translate to upward pressure on prices. And we also don't see firms hiring when their profit margins are compressed from higher input costs. So ultimately we do envision below trend growth in both consumer spending and overall GDP growth in the US. Right. And you said earlier that if anything, the latest data releases have added to your conviction that the stagflation light scenario is currently playing out. So can you maybe unpack for us? Will we note now that we didn't know a couple weeks ago? Maybe start with prices? Okay, yes. I think this is a great place to start. So the CPI data in the US is looking stronger with cornflation up at 3.1 per cent year every year, but it will say the July inflation data doesn't fully capture the impact of tariffs just yet. This is not surprising. And this is also fully aligned with what we've been writing about over the past few months. We had a pretty sizable buildup of inventories earlier on in the year, meaning businesses were stocking up on their goods before tariffs were implemented. A think, by and large, we're likely still depleting these inventories. So for example, if I'm going to go by clothing in a store, chances are I'm still paying pre-tariff prices because that item was likely stocked before tariffs were imposed. And this makes sense because in July, core services actually outpaced core goods prices. Now where we're actually starting to see the early impact of tariffs is in the PPI data, which measures producers selling prices rather than the prices paid by consumers. It's often overlooked in favor of CPI data, but PPI actually has some really important clues for how CPI is going to look in a few months. And this is because the first step of inflation when it's not demand-driven is we see manufacturers or producers charging higher prices to wholesalers or retailers who will later on pass those off to consumers, which will then show up in the CPI data a few months down the road. And we are already seeing signs of that in the PPI data, you said? Yes, so we did see some early signs of it. PPI data posted a huge upside. It was up 9/10 month of our month in July, which was well above consensus. We actually saw pressure in three key areas, so there was food, transportation, and warehousing, and trade services. Higher food prices makes a lot of sense because inventories of non-durable goods can't be held on to for as long, right? And food products spoil. So this actually nudged us to bump up our food inflation forecasts for August. We think it's going to show up in the CPI data sooner. We also saw upward pressure in transportation and warehousing, which is a trade exposed sector. And lastly, trade services. And this one is interesting because trade services PPI is actually a measure of margins between the prices that producers receive from non-manufacturers buying their product and what they paid for those products. So we're seeing margins widen in this sector. We think this is temporary and we think what's happening here is that firms are front-running their expectations of tariff pressures and are passing that on to buyers. They're able to do that in preserved market share because all producers are in the same predicament where tariffs are concerned. That makes sense. So realistically, how long do you think it'll take before these pressures are actually fully captured in the CPI data? So we expect that we'll likely see this a few months down the line. Our base case calls for cornflation to reach 3.4% by year end. And since we're already 3.1% and have yet to see tariffs fully show up, I think we're on track for that trajectory. Okay, so we've talked about the inflation side of the stake flation lie scenario and now I want to talk a little bit more about the stake part of it. Have we seen any signs of slowing growth in the US? Well, first I want to talk about where we haven't seen it and that's in the retail sales data, which has still held up relatively well. After adjusting for inflation, we've seen real retail sales growth of about 1% since December, which it's not strong by any stretch, but it's also not weak either. And this is interesting because the July data pointed to stronger durable spending on set of Q3. Maybe though this is still a function of tear front running. We don't expect momentum to last indefinitely, not as consumers feel the pinch of price growth and firms are going to materially hike wages if they're not hiring. But let's get back to where we're seeing the stag component of stake flation. And that's in the labor market. A few weeks ago, the markets reacted to sizable revisions to non-farm payroll employment data. As a cold notes version, we initially thought that the US economy added 291,000 jobs in May and June and it turned out that it actually only added 33,000 jobs. That's a pretty massive downward revision. Exactly. So nearly 90% of the job growth that we thought happened over those few months didn't actually happen. And most of the revisions outside of local education happened in trade exposed sectors. In general, we've seen hiring freezes across the board, which means that job seekers are struggling to find work. The unemployment rate has crept up to 4.2% and we expect it will likely get to 4.5% by year end. As firms facing tariff impacts and massive uncertainty, surely are not opting to ramp up hiring. Right, that makes sense to me. So on the one hand, we have pressures building on the inflation from from tariffs. And on the other hand, job growth is actually a lot weaker than they looked from initial data releases. Exactly. And this is really just the beginning of stagflation light. Okay, so before we conclude, I do want to zero in on why this matters for Canada. Well, Canada is a country that's one of the least impacted by tariffs. slower growth and consumer spending out of the U.S. is likely to translate to weaker demand for Canadian exports. Canada is already most exposed to an underperforming U.S. manufacturing sector. And now tariffs just further compound that issue. With that, it's time to wrap up. To some things up, the latest data points in the U.S. added to our conviction over stagflation light base case. We have tears flowing through to consumer prices with a lake. And we're likely just a few months out of that fully being captured with price pressures already starting to show up in the PPI data. The employment data on the other hand has started to soften as we have seen pretty sizable downward revisions in employment among trade exposed sectors. This signals that we're likely reaching a turning point in the labor market. Finally, so our growth in the U.S. will spill over the border to slow growth in Canada as well, something we've expected due to incredibly well-integrated demand and production chains. This concludes this week's episode of The 10 Minute Take. We're economists from RBC and we research cutting-edge macro trends through the lens of millennials. We're here to filter out the noise and tell you everything you need to know in under 10 minutes. Thanks for listening and talk to you in two weeks.