Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / The Fed's October Surprise and the Stagflation Trap
Transcript
- Lucas: Look at the chart right now. The Dow is sitting at fifty-two thousand four hundred ninety-six, up nearly two percent over the last five days. Meanwhile, the Nasdaq is down a full point. It feels like the market is trying to have its cake and eat it too, but the underlying data tells a much more uncomfortable story about where we are in October of twenty-twenty-six. Luna: It’s that classic bifurcation we’ve been seeing, isn’t it? The heavy industrials and financials are propping up the index while the growth stocks are getting squeezed by higher for longer rates. But I’m less worried about the tech slump and more worried about the fiscal side. Lucas: Right. Because if you look at the headline from Friday, the U.S. budget deficit has swelled to almost two trillion dollars for fiscal twenty-six. That is a twelve percent jump in a single year. We are talking about a government that is borrowing at historically high real rates to fund operations that aren't generating productivity gains. This is textbook stagflation fuel, yet the bond market seems largely indifferent. Luna: Exactly. The ten-year breakeven inflation is stuck at two point three five percent, flat as a pancake. Investors are pricing in that the Fed will keep a tight leash on price rises, even as the Treasury dumps more debt into the system. It’s a dangerous disconnect between fiscal reality and monetary perception. Lucas: And here is where it gets interesting for our listeners who remember the seventies. In that era, the Federal Reserve was often forced to prioritize employment over inflation because the political pressure was immense. Today, we have a different dynamic. We have an independent central bank that is technically insulated, but they are operating in a world where the Treasury is essentially printing money to cover the interest payments on previous debt. It’s a feedback loop. Luna: So you’re saying the Fed might be forced to act not because inflation is exploding, but because the cost of servicing this two-trillion-dollar deficit becomes unsustainable? That sounds like a liquidity crisis waiting to happen. Lucas: Precisely. And that brings us to the person everyone is watching this week: Kevin Warsh. If he pushes for a surprise rate hike in October, despite the broader consensus holding steady, he would be signaling that the Fed sees the fiscal dominance risk clearly. Most analysts expect them to hold rates, but Warsh’s presence suggests a hawkish minority that believes the deficit expansion is the primary inflationary threat now. Luna: That’s a bold move. Hiking when real GDP growth has already slowed to two point two percent? That’s barely above the line for stagnation. You’d be choking off what little growth remains just to signal discipline to the Treasury. Lucas: It’s a gamble. If they hike, they risk triggering a recession in the services sector, which is already showing signs of strain. But if they don’t, and the deficit keeps expanding, the long end of the yield curve could spike anyway due to supply fears. We saw gold jump to four thousand one hundred thirty-four dollars today. The market is hedging against currency debasement, not just consumer price inflation. Luna: I think the gold movement is the key indicator here. It’s not just about CPI; it’s about trust in the dollar’s purchasing power relative to hard assets. When you combine a two trillion dollar deficit with stagnant wage growth—average hourly earnings are only up slightly to thirty-seven dollars—it means consumers are being taxed by both inflation and interest costs simultaneously. Lucas: Let’s drill into that wage detail. Average hourly earnings for private workers are at thirty-seven dollars, up from thirty-seven dollars and seventy-six cents last month. That is marginal growth. With core PCE still rising, real wages are effectively flat or negative for many households. This is the 'stag' part of stagflation. Growth is slow, and prices are sticky. Luna: And job openings are down to seven thousand seventy-nine thousand. The labor market is cooling, which usually gives the Fed room to cut. But if they cut while the deficit is exploding, you get reflation. So they are trapped between hiking and causing a downturn, or cutting and igniting inflation. Lucas: It’s a no-win scenario unless the Treasury steps back, which it won’t do. This is why I find the comparison to the seventies so compelling. Back then, the Fed was passive. Now, they are active but constrained by political realities they can’t ignore. The housing market is flashing warning signs too, with rates keeping affordability out of reach for most buyers. Luna: Housing is the canary in the coal mine. If home sales drop further, construction slows, which hurts employment in trades and materials. It creates a multiplier effect that hits the real economy faster than the services sector. Lucas: Before we go deeper into the mechanics of how this might play out in Q4, I want to take a brief moment to talk about the show itself. Walking through these complex economic dynamics with us has hopefully made something click for you regarding how policy affects your portfolio. Our work is ad-free and independent, sustained entirely by listener support. If you value this kind of deep-dive analysis, please consider supporting us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. It helps us keep the research rigorous and the commentary sharp. Luna: Yeah, it really does make a difference. Knowing that you’re behind us allows us to dig into these specific data points rather than just skimming the headlines. Thanks for keeping the lights on. Lucas: Back to the trap. So, if we assume the Fed holds rates in October, as the consensus expects, what happens to the deficit narrative? The market seems to be ignoring the fiscal risk for now, but that ignores the law of large numbers. Interest payments alone are becoming a massive line item in the budget. Luna: They are crowding out everything else. Education, defense, infrastructure—it all gets squeezed. Eventually, the Treasury has to choose between raising taxes or issuing more debt. Raising taxes kills growth, issuing more debt kills the currency. There is no third option right now. Lucas: Which brings us back to Kevin Warsh. If he argues for a hike, he’s essentially saying, 'We need to break the inflation expectation before the fiscal dominance takes hold.' It’s a preemptive strike. But does he have the votes? The FOMC is diverse, and many members are looking at the unemployment rate, which ticked up slightly to four point two percent. They are cautious. Luna: Cautious is an understatement. With initial jobless claims rising to one hundred ninety-nine thousand, the labor market is softening. A rate hike now could push that number over two hundred thousand, which would be a clear signal of trouble. The Fed doesn’t want to cause a spike in layoffs. Lucas: But if they wait until the data is undeniably bad, it’s too late. That’s the mistake they made in the sixties and seventies. They waited for unemployment to hit five percent before acting, and by then, inflation was entrenched at nine percent. The lesson is that you have to act on the fiscal trend, not just the current CPI print. Luna: So you’re suggesting that the Fed should be targeting the deficit trajectory as a secondary mandate? That’s a huge shift in their framework. They currently only target price stability and maximum employment. Lucas: Not officially, but functionally, yes. Because if the deficit fuels inflation, ignoring it is negligence. We’re seeing this in the commodity markets. Silver is up two percent, gold is up nearly one percent. Investors are moving out of fiat and into tangible assets. It’s a vote of no confidence in the current policy mix. Luna: It’s interesting that the small caps in the Russell are up one point six percent. Usually, they get crushed in high-rate environments. Maybe the market thinks a recession is coming, which would force the Fed to cut later, benefiting them in the short term. Or maybe it’s just a rotation away from expensive tech. Lucas: Rotation is possible, but don’t bet on it being sustainable. Small caps are highly sensitive to credit conditions. If the deficit forces long-term yields higher, their refinancing costs explode. The current rally might just be the calm before the storm. Luna: Or the storm is already here, and we’re just not feeling it yet because the energy sector is absorbing the shock. But with global growth slowing, demand for oil and commodities might peak soon. That could actually help bring inflation down, ironically. Lucas: That’s the hope. But given the geopolitical tensions and the supply chain frictions we discussed in earlier episodes, a demand-side deflation might not happen fast enough to prevent a supply-side shock. We are walking a tightrope between a soft landing and a hard crash. Luna: A soft landing requires the Fed to cut without breaking the bank, and the Treasury to reduce spending without crashing the economy. Both seem impossible right now. It feels like we’re in a period of managed decline rather than growth. Lucas: Managed decline is a polite way to put it. What we’re seeing is a restructuring of the global economic order. The U.S. is trying to maintain its reserve currency status while running massive deficits. Other nations are watching closely. India’s finance minister recently commented on market liquidity, suggesting investors can exit easily. That ease of exit is a double-edged sword. Luna: If sentiment turns, that liquidity evaporates instantly. Capital flight is a real risk if the dollar loses credibility. That’s why the breakeven inflation rate is so critical. If it starts ticking up, even to two point five percent, it signals that the market is starting to price in a loss of faith. Lucas: Until then, we wait for the Fed’s move. Whether it’s Warsh’s surprise or a consensus hold, the direction matters less than the follow-through. If they hold, do they signal future hikes? If they hike, do they admit the fiscal problem? Either way, the narrative is shifting from 'inflation is gone' to 'inflation is structural.' Luna: And that changes how every investor allocates capital. No more simple index funds. You have to hedge against currency risk, fiscal risk, and policy risk. It’s a much more complicated game than it was five years ago. Lucas: It is. And for the average listener, it means diversifying beyond just stocks and bonds. Thinking about real assets, thinking about geographic diversification, and understanding that the rules of the game have changed. The seventies weren’t a glitch; they were a feature of a certain type of economic policy. We might be repeating history. Luna: Hopefully, we’ve learned enough to avoid the worst mistakes. But learning from history is easy until you’re living through it. Keep your eyes on the deficit and the Fed’s next move. That’s where the truth will be revealed. Lucas: Agreed. As we head into the rest of October, watch the bond yields. If they rise while the stock market stays flat, that’s your warning shot. Stay curious, stay skeptical, and we’ll see you in the next episode.