Stag vs. Flation
Michael Drury, GIC Board Member and Chief Economist of McVean Trading
March 27, 2026
President Trump has extended the pause on attacking Iran’s energy infrastructure until April 6th – the day after Easter. If he extends it again until April 10th – the day Passover ends – it will be truly biblical at forty days and forty nights. The standoff between the Democrats and Republicans appeared to have ended after its 40th day, with neither side gaining any concessions. However, the House passed their own bill – and the President signed an executive order to pay TSA. So, the standoff on the rest of Homeland Security, especially ICE, will continue. There is plenty of funding in the short run, and a reconciliation bill requiring just 50 Senate votes is likely. Hopefully, the developments will reduce congestion in time for those returning from Spring Break – and our travel in Monday!
The President says the reason for the delay on Iran is because negotiations are going well – but at the same time the Defense Department appears to be sending another 10,000 ground troops to the Middle East, in addition to the 5,000 Marines and 1,000 Airborne already committed. The delay may simply be to provide time for military assets to get in position. The Marines came from Okinawa and San Diego, while the Airborne is specifically designed for fast deployment. It took six months for enough troops to be positioned to carry out the original Desert Storm. Or perhaps the appearance of long preparations opens the opportunity for surprise? Markets remain wary.
All we really know is that oil prices and interest rates have moved back up as investors gird themselves for a riskier environment. As we write, WTI is trading just below $100, and Brent is over $112, US ten-year notes are at 4.43% — and the two year is at 3.91%, having broken 4% momentarily, with a better than 60% chance of the Federal Reserve tightening once over the next year. Interestingly, while the rise in two-year note reflects the Fed’s more hawkish stance against oil inflation, the five-year-five-year inflation outlook – which has been coming down since the Warsh nomination – took another leg lower to 2.11%. Thus, most of the rise in the ten-year rate has been due to higher real rates, not inflation.
With higher interest rates – particularly real rates – and higher oil prices, we are much more worried about the stag- part of stagflation than the Federal Reserve’s concern about inflation. While we fully understand that reported CPI and PCE inflation are likely to spike in March data, we also are pretty certain that income for both consumers and businesses did not go up as dramatically during that period – so just as real rates rose, real income for everyone fell. With less real buying power, real spending and real GDP will also fall, unless everyone taps assets or credit to offset the shock. While we have been strong advocates for how high US wealth holdings provide protection against precisely this kind of economic event – it is also clear that not everyone has the wherewithal to pay more at the pump and still maintain all other economic activity. Thus, we expect a slowdown in real economic activity in March – and April, and until prices other than oil moderate enough for consumers’ slightly slower nominal spending to translate into more real spending.
Given that real economic growth was running somewhere north of 2% before the oil shock – and because reported real government spending will rebound sharply in the first quarter – we do not see any risk of weak growth. Indeed, the fourth quarter’s soft 0.7%, plus the first quarter number, could still average over 2%. Anything north of 1.5% should be enough to maintain the no hire, no fire equilibrium that underpins US economic expansion.
Looking at history to see how an oil shock hits the economy is fraught with the need to understand the structure of the economy before the shock. We argue that looking at anything from the 1970s is a waste of time. The US economy has changed dramatically since then – as we noted a couple of weeks back, primarily because we did experience the 1970s. Beyond Volker, to cool inflation, Reagan opened the US economy to allow more free trade – which meant more inflow of cheaper imports, to the chagrin of US unions who benefitted from a wall around US production. Companies moved factories to lower cost right-to-work states, or away to Mexico, then Asia. Private sector unions have all but evaporated as a result. Most durables goods – which are at the greatest risk from a demand shock due to rapidly rising energy prices – are now imported, transporting any cutbacks in production abroad. Moreover, The US became a net energy exporter in 2019, as the effects of fracking shifted the balance of energy production to the US favor.
Conversely, the oil shock of February 2022 due to the start of the Ukraine war, was effectively offset by the money drops of 2000 and 2001, which provided those at the bottom of the K – who are now most effected – with the savings needed to absorb the higher prices at the pump. Today, that segment is being cushioned by the reduction in tariffs from an average around 20% to 10% and by higher refunds — if they can take advantage of the new form 1-A with no taxes on tips or overtime, deductions for auto interest, and a higher exemption for the elderly. Those provide a fraction of the income from the money drops. Moreover, as discussed a week ago, the rest of us have not received bigger refunds this year – for though the average is up 10.6%, nearly all of the increase has accrued to those filing schedule 1-A.
The vast bulk of the volatility in consumers’ spending on energy is in energy commodities (motor fuels) – while spending on energy services (residential heating and cooling) has been very stable, but declining slightly from 2.7% of spending in 1992 to 1.7% today. Headed into the Iran attack, spending on gasoline was under 2% of GDP – which means the 33% hike from $3 to 4% represents an 0.67% tax on consumers, that is paid to domestic producers. While producers are benefitting, they have not been reacting. The Baker Hughes rig count, down 1 rig to 555 this week, is the second lowest of the past year, and 41 below a year ago. This is despite the fact that one can sell deferred oil a year away at $74, which is generally accepted as above the breakeven for fracked wells. Unlike offshore or traditional drilling, fracking has a fast start as many wells are already drilled (multiple possible from one pad), and a short lifespan — making a year out price an attractive target. It seems producers are anticipating demand destruction at current gas prices. They are likely right.
We are hardly against the market pricing in a rate hike over the coming year – as we have been arguing for quite a while that rates are too low with nominal growth over 5%. We are hardly monetarists, but we are institutionalists – and looking at bank behavior today, it is clear they were expanding the money supply well before the Iran shock. Very strong demand for credit is the cause of inflation; price hikes are the result. As the squeaky wheel gets the grease, recently inflation has been in concentrated in capital goods, rather than the consumer prices that are the Federal Reserve’s preferred focus. As we have discussed many times, this is primarily because the consumer accounts for two-thirds of the economy. Yet, it is clear from the 3%+ pace of the GDP deflator, that overall inflation has not cooled along with consumer prices.
Now, theoretically, capital goods inflation should be a lagging indicator. It swells when businesses shift to greater dependence on capital as unemployment contracts. Falling unemployment typically means a stronger economy and higher profits – and, not unexpectedly, capital spending rises with a two-year lag to profits. Thus, consumer spending inflation, which is generated because demand from higher employment rises faster than supply, should be the lead indicator. Indeed, this is clear from the fact that productivity usually rises fastest during recessions – due to layoffs – but is weaker early in the expansion as the rebound in labor outpaces the resulting boost in supply. This simply confirms that employers keep the most productive, and profitable, workers during recessions, then hire back the less productive labor during recovery. Consumer prices also rise due to the rebuilding of inventory pipelines after a recession, as that is competition for the supply their labor produces. That could be a problem with oil prices when the Straits reopen.
The recent surge in capital spending – and consequently in prices for its inputs — is from expectations that AI will replace white collar labor, which is more expensive than and has a lower unemployment rate that blue-collar (the traditional target of increased equipment outlays globally). Firms are so certain of this potential that they are increasing credit demand, which leads banks to compete for funds in the overnight market. Rather than allow the overnight rate to rise, the Federal Reserve increases reserves – which is reflected in a faster increase in bank assets. Since late 2025, bank assets have been rising faster than nominal GDP, which is a harbinger of higher prices. Bottom line, rather than focusing on potential consumer inflation due to the supply bottleneck at the Straits of Hormuz — the Fed should be worried that the global focus on AI is generating bottlenecks in that supply chain that will sustain increased demand for credit. Given the behavior of equity markets, we doubt a single rate hike would blunt AI fervor at all. More will be needed.
We are concerned that during the build-up phase of a capital spending boom – like during an increase in defense spending – the income paid to labor does not produce consumable goods. That too is an inflationary force that is unrelated to the Straits. However, a $200 billion increase in defense spending as a byproduct of this war would threaten higher prices. Bottom line, we do not see a big enough threat from the stag- caused by oil prices to offset the inflation we see from capital spending and defense, so the risk is that prices will move higher this year regardless of the outcome in the Gulf.