Swonk Sees Emerging Stagflation Risk

Diane Swonk has been analyzing the U.S. economy and the path it paves for the Federal Reserve’s monetary policy long enough to sniff a trend from the past returning that most are not quick to see.

With tariffs helping to push up inflation that remains above the Fed’s 2% target and the DOGE driven government layoffs helping to erode perceptions of the job market “it’s one of the worst combinations for the Federal Reserve because it hearkens back <to> something that sadly you and I remember from our childhood… but people don’t remember: the idea of stagflation.”

Will today’s Consumer Confidence report from The Conference Board start stirring the pot after confidence dropped sharply and inflation expectations took another leap higher?

Dive in and hear what Diane has to say on this and so much more, from the reasons why laying off IRS workers is something Elon Musk should never do to why stainless steel sinks are going to be hit hard by Trump’s tariffs. And why she is certain the Fed will be doing no rate cuts at all this year and won’t take those steps until well into 2026.

Inflation expectations soar/job market perceptions sour 00:01:02.980 --> 00:01:46.690

• The University of Michigan consumer sentiment survey for the month of February as well…saw this huge increase in inflation expectations driven by tariffs. And it's been going on now for 3 months, so it's not just a 1 month blip.…marry it with the deteriorating Conference Board <that> is much more sensitive to the job market, and you've got to believe that some of these headlines that we're seeing in terms of Federal firing are affecting people's perceptions about the job market as well. But we're also seeing some large firms make some announcements as well. And so looking at that, it's an odd combination to have…
  

  Is it Stagflation?? 00:01:46.690 --> 00:02:11.530

  …inflation expectations going up when people's perceptions about the job market are also deteriorating, and it's 1 of the worst combinations for the Federal Reserve, because it harkens back on something that sadly, you and I remember from our childhood, I would say, but people don't remember the idea of stagflation, and that's where you know a really, you see a rise in inflation
  

  Dead spots in the economy? 00:02:11.530 --> 00:02:36.490

  …and a rise in unemployment? Now, I don't think we're going to see a big rise in unemployment in the month of February. And also we've got things going on and changes in immigration policy which are going to hold down participation in the labor force and the overall unemployment rate, but leave pockets of acute labor shortages as well. And I think that's really all these things together
  

  Uncertainty strikes 00:02:36.490 --> 00:02:48.679

  …we're looking at the effects of uncertainty and what that does to all sectors of the economy as well.
  

  It’s not just tariffs 00:03:48.520 --> 00:04:13.469

  I think you're exactly right. It's much more complex than tariffs alone. Tariffs are the biggest thing that people hook onto. We do know that in the construction sector we saw some front running of tariffs where they're actually padding their margins ahead of tariffs. So they're raising prices. We also know the bird flu is going on, and let's face it. A carton of eggs, which is the most important protein for low income households, is going up in price.

  Still expecting PCE moderation in January 00:04:13.470 --> 00:04:38.459

  We're expecting the PCE index that comes out, you know, this week for the Federal Reserve to come in at 2.6% on the core. That's lower than the 2.8% we saw. And we get some improvement, because as we round the corner on January.

  Inflation turns on inflation comparisons 00:04:38.460--> 00:05:03.199
  We had an acceleration a year ago, and we get better year on year, but that's still well above anything the Federal reserve considers stable prices, and they've already, you know, moved to the sidelines, paused rate cuts, because the war on inflation is not yet done and not yet won. I think that's important as well, and those factors are seeping in.
  

  High vehicle prices and two winter storms 00:05:03.200 --> 00:05:47.089

  Vehicles are expensive, extremely unaffordable. But there was a real flip in the narrative, not just with tariffs, but also with tax credits for electric vehicles and the fear that those would disappear. Now there's been executive orders on that. Of course, Congress has to actually act on that. And in that window we saw the highest electric vehicle sales in December that we've ever seen on record, and I wouldn't be surprised to see a bounce back in February, because much of the weakness we saw in the month of January was not due to these deteriorating consumer attitudes. They were really because we had 2 really bad winter storms in places we don't usually had them. We have snow in the Gulf coast. We had snow in Louisiana.

  Tariffs hit the kitchen sink 00:06:38.320 --> 00:07:01.390

  We're literally talking about Tariffing your kitchen sink. It is. There is no the amount of waivers and carve outs that were in the original rounds in 2018 and 2019 are not there. Stainless steel sinks are going to be under that 25% aluminum and steel tariff, and they're going to be hit. And these are important things that you know you don't think about.

  Broader group of products 00:07:01.390 --> 00:07:26.189

  It's much broader, based on a larger group of products than we actually expected, because there's some things that we import like steel from Canada. And if we smelt it here, that doesn't get the 25% tariff. So there are some things that get in under a wire, but the Administration has really narrowed that road in terms of getting in underneath tariffs and the speed with which they're trying to ramp up. Tariffs are is really quite unusual.
  

  Travel has been popular 00:08:07.970 --> 00:08:29.970

  Yes, and we had. We had terrific services, you know. Record travel during the holiday season, and in the month of December, before we even got to that. December 21st to January 1st travel season. We had the largest number of people out on vacation in December, ever since 1976, since the records were being kept for the month of December, middle month.
  

  Bumpy road ahead 00:08:57.590 --> 00:09:43.980

  There is some hurdles that by the time we get into March, depending on whether or not these reductions in force that we've seen at the Federal level, and the spillover effect and furloughs to nonprofits and grants and educational system institutions, state and local governments. How much they stick we could easily see red ink in their employment report as soon as March, which is, comes out in early April. That is not something we are expecting, and that depends on how the courts handle what has already occurred.
  

  Spending concentrated among the rich 00:09:43.980 --> 00:11:10.390

  Moody's economics, Mark Zandi, works on this… the top 10% by their data, the top 10% of income earners are now accounting for almost 50% of overall consumer spending which gets to something I had written about earlier, Kathleen, and it was, you know, mind the gap, the gap between the dissonance between how consumers were saying they were feeling about the economy, and how the economy added up on paper, because it's added up on paper to look extremely good. Yet that idea that we're seeing much more unequal. That was the most inequality going back in the history of his data to 1989 that they've ever seen. And I think that's part of it as well is that the overall economy is driven by a smaller group of consumers that are very well to do, including baby boomers. Among the top 15 retirement markets. 13 of them are outperforming in retail sales than the overall economy.
  

  Tariffs are causing buying to shift forward 00:13:01.300 --> 00:13:40.489

  We got a bit of a pause in January because of the weather, but people are now buying ahead of what they see as a loss in tax credit and potentially a rise in tariffs. That kind of behavior is its own self-fulfilling prophecy and the fact that we've also seen a lot of companies trying to front run tariffs in December, actually on China by ordering ahead. I know it's public knowledge that a Solar company ordered all their solar panels for the entire year ahead of time. So those things are important because it does leave the Fed much more leery about. Certainly cutting again.
  

  Tariff sequencing 00:14:32.870 --> 00:14:56.910

  We're talking about sequencing a lot of tariffs. And we're talking about unlike 2018 and 2019, when not only were inflation, expectations well anchored, we do know that the few things that were tariffed actually were passed on to consumers.
  

  Consumers now have had a taste of inflation, they know or fear it
  00:16:31.040 --> 00:16:48.689

  Unlike in 2018, where we hadn't seen any inflation for decades upon decades, and if anything, a lot of deflation in goods prices. Now we're in a situation where you know our feet are not in that cement anymore when it comes to inflation, expectations being anchored.
  

  Government inefficiency 00:17:47.520 --> 00:18:15.399

  We knew that from the pandemic, you know, all the unemployment stuff was running on code that was written 50 years ago, you know, really crazy kinds of things, and that opens the door for fraud. You don't want that. You want to increase efficiency. I would like to see people fired who are underperformers.

  
  The IRS is cost-effective 00:19:22.460 --> 00:19:54.019
  …the IRS is one of the few things that Congressional Budget office nonpartisan. When you spend more money on Irs agents, it actually increases our tax collections because of tax evasion and narrows the deficit it pays for itself. It's the only sector everyone hates the Irs, but it is the only line that when government spends money it actually pays for itself, and then some very rapidly.
  

  Soft-landing is now harder to achieve 00:21:00.200 --> 00:21:46.009

  <Inflation over target for 45-months> is a very large concern. We do not have the Fed cutting rates through mid-2026, and that's our. We have 3 different tariff scenarios, and we're updating those as we speak. But we're concerned that the narrative on a soft landing is getting undermined because part of the narrative of a soft landing was that we had this influx of immigration and immigrants that fill jobs that oftentimes natives did not fill, and that helped to bring the labor market back into balance. Very much so. And now that's changing, we all can agree. We need immigration reform. But the bottom line is that immigration influx was a big part of the soft-landing scenario, and it makes it much harder to achieve now where we are today.
  

  NO rate cuts ahead 00:21:57.980 --> 00:22:25.720

  No rate cuts… Nada, because we actually see the inflation from tariffs. We're the 800 pound grill in the room. Anything we do hits our trading partners harder than it hits us. So they've got to play guerrilla warfare back and be very strategic, and those longer supply chains are sadly, very vulnerable, and that could mean even more inflation and more of a stagflationary situation.
  

  Labor shortages 00:22:25.720 --> 00:22:50.410

  We're also talking about, you know, labor shortages in things like construction which are already acute. Now you add on to that. That's a sector that happens to depend a lot on immigration. So does elder care in-home care. Childcare agricultural sector which have asked for waivers. But we know from the 2,010 s. When you start to have deportations, there's a lot of people just opt out and actually leave.
  

  Base case 00:23:40.430 --> 00:24:05.379

  So our base case has the economy slowing down almost to a stall, speed and inflation slowing down as we get into mid-2026. We also have a change in governors. The Fed chairman in mid-2026, that we think will be more amenable to rate cuts than Jay Powell will be, and all of those things together suggest. We'll start to see rate cuts. Now, the cooperation of the bond market.
  

  The Bond market 00:24:05.380 --> 00:24:29.329

  What happens with the bond market will depend heavily on our forecast. That inflation is actually beginning to cool again after it peaks in early 2026. We see it coming off after it, peaks, and that's contingent on, you know, a slowdown in the situation, with tariffs and sort of hitting a peak level of tariffs, and that's starting to stabilize and work its way out of the economy.
  

  The deflationary tariff risk 00:24:29.430 --> 00:24:54.100

  The other issue, you know, is when our tariffs deflationary. Well, we know 1930 a year into the Great Depression. Not quite. We did the largest tariffs ever you know that we had done in recent history almost 100 years ago. Now we had trade wars with 25 countries and trade globally fell by 67%. That was deflationary. That is not where I want to go.
  

  It may walk and quack like one but it not a recession 00:25:03.880 --> 00:25:25.489

  We don't have <recession> in our baseline forecast, but a stalling out of growth is about, you know, if it walks like a duck and quacks like a duck. It's a duck. Does unemployment increase enough with the loss in immigration? It's unclear to call it a recession, but it's flirting with it, and it certainly is an economy that's much weaker than the economy we see today.
  

Diane Swonk
KPMG LLP Chief Economist

Diane Swonk started her career with money-center bank First Chicago and has won many awards in her career for her excellence in her profession and leadership in the broader business community. She climbed from entry-level to Director of Research and Chief Economist at Bank One, the merged bank. Before joining KPMG, Diane had her own economic consulting firm and worked at Grant Thornton. She spent the prior 10+ years as Senior Managing Director and Chief Economist at the financial services firm, Mesirow Financial.

She served as an advisor to the Congressional Budget Office (CBO) and the National Economic Council (NEC) on a nonpartisan basis. She regularly briefs the regional Federal Reserve banks and the Board of Governors in Washington, DC. She has provided Congressional testimony on income inequality and how to preserve and bolster the quality of government statistics on the economy.

She was honored by her peers as Fellow of the National Association for Business Economics (NABE) for her outstanding contributions to the field. She serves on the NABE statistics committee to advocate for better information on the economy. Diane serves on the board of the Posse Foundation in Chicago, an organization dedicated to increasing access to higher education. She is active in supporting scholarships and programs to diversity the ranks of economists with more women and underrepresented minorities with her alumni groups and work on the NABE Foundation. She is a member of many business groups, including the Economic Advisory Board of the US Chamber of Commerce, and the Council on Foreign Relations.

Diane recently took over the growing economics team at KPMG to serve partners and clients, and to engage with the media to help showcase the firm’s many achievements. Diane was named one of the top 50 most influential economists during the pandemic. She has won numerous awards through the financial press and been recognized for her excellence in forecast by the regional Federal Reserve banks.