Supply-demand dynamics pointing to recession

Supply-demand dynamics pointing to recessionMacquarie Fixed Income | October 2022


Graham McDevitt

  • Managing Director, Global Strategist
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Sophie Photios


Patrick Er

  • Senior Manager, Senior Econometrician
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Executive summary

As markets continue to grapple with supply-shock-induced “stagflationary” conditions across much of the global economy, we think we detect signs of the next evolution of the macroeconomic environment. This has been triggered by the emergence of two opposing forces: supply recovery and demand deceleration. Whichever of the two dominates will determine the economic landscape in the short to medium term, in our view. Increasingly though, the influencing hand will likely be played by policymakers, whose determination to tighten economic policies could turn demand deceleration into demand destruction, which might surpass supply recovery and deliver the unintended consequence of a deeper recession without inflation reducing sufficiently to desired target ranges.

Introduction: Stagflation is the here and now but maybe not for long

As of this writing, about two years on from the global COVID-19 pandemic supply shock, sizeable tracts of the global economy, especially the majority of developed countries, are experiencing stagflationary or near-stagflationary stagflationary conditions.1 Just as tentative signs were emerging that the impact of the pandemic shock was fading, a second negative supply shock in early 2022 from the Russia-Ukraine war clearly exacerbated the situation, in our view. Figure 1 illustrates this shift to higher inflation and lower growth.

Figure 1: Supply shocks drove many countries into stagflationary conditions

Chart 1

Sources: Bloomberg and Macrobond, September 2022.

Supply shocks and the resultant stagflations are, thankfully, in our view, rare events in the post-World War II era. Stagflation tends not to persist because the instability naturally motivates households and businesses to react in ways that counter the adverse conditions. In addition, policymakers tend to enact measures in response to the forces that cause stagflation. So even though the second supply shock from the war in Ukraine caused stagflationary conditions to stick around for longer, the adjustment mechanism remains intact. Thus, stagflation environments are usually transitory.2 We believe it is timely to explore and determine the nature of the next evolution of the economic environment as the transition from stagflation begins.

Determining the path out of stagflation: The war between the forces of demand and supply

Supply recovery slow but steadily progressing

The recent evidence points to the clear improvement in each of the three dimensions of the supply problems faced since 2020: production, transport/logistics and labour (see Figures 2-a to 2-c below).

Figure 2-a: Production

Chart 2A

Sources: Bloomberg and Macrobond, September 2022.

Figure 2-b: Transport / logistics

Chart 2B

Sources: Bloomberg and Macrobond, September 2022.

Figure 2-c: Labour

Chart 2C

Sources: Bloomberg and Macrobond, September 2022.

Global COVID-19 restrictions have progressively ended everywhere; even China’s zero-COVID policy has not severely curbed production growth thanks to unconventional measures to maintain economic activity. While the RussiaUkraine war is still on-going, various bilateral political efforts have enabled the disruption of the supply of essential goods and services to, so far, be kept away from the worst-case Armageddon scenario. Geopolitical risks persist and the risk of conflict escalation cannot yet be fully discounted, so we remain alert to any further supply setbacks. For now, supply improvements continue.

Demand destruction accelerating

Demand recovered quickly from the depths of the COVID-19 supply shock thanks to unprecedented fiscal and monetary support around the world. However, once this support ended, the momentum of recovery faded, with most countries failing to progress much beyond the real- or inflation-adjusted pre-pandemic trend of growth (see Figure 3).3 As a result, prevailing stagflationary pressures began to adversely impact demand. For example, inflation (via nominal wage rises) may enable households to have more money, but they are effectively worse off because they are paying more for less.4 Meanwhile, businesses, despite passing on cost increases, have clearly, in our view, seen the writing on the revenue wall with a growing reluctance to commit to more capital expenditure. That is why leading indicators of economic activity have consistently indicated (and are still indicating) slower growth ahead (see Figure 4).5

Figure 3: Activity gaps relative to pre-COVID-19 growth trend, as of 2Q22

Chart 3

Sources: Bloomberg and Macrobond, September 2022.

Figure 4: Leading economic indicators

Chart 4

Sources: Bloomberg and Macrobond, September 2022.

In summary, the transition out of stagflation will likely be led by the two (opposing) forces of supply recovery and demand deceleration. We think a definitive consequence is that inflation should be peaking (if not already) and on its way down. A combination of rising supply and falling demand should have no other impact on inflation. In our view, the effect on growth is a bit more ambiguous; if supply recovery exceeds demand deceleration, then economies can avoid recession (the hoped-for soft landing). But the reverse, that is, demand deceleration surpassing supply recovery, could significantly raise recession risks. This is where we believe the deciding hand will be played by policymakers.

Policy turning the screws on demand: The unintended consequences

At Macquarie Fixed Income’s May 2022 Strategic Forum, we offered the view that policymakers who attempt to fix the high inflation and slow growth using demand management tools will likely end up not only failing to achieve their targets but instead worsening the “stag” part of it. The more they press ahead with these measures, in our view, the more they will cause an unintended hard landing – a recession without much payback in lower inflation. Today, those concerns are being increasingly realised.

Central banks globally have embarked on a sustained monetary policy tightening cycle. Some, like the US Federal Reserve and the Bank of England, have enacted the fastest and greatest rate hiking cycle in the post-Bretton Woods era. What is less noticed is that fiscal tightening is also occurring at a significant pace.

In the US, for example, budget deficits have nearly reverted to the pre-COVID-19 trend, indicating significant withdrawal of net income, that is net funds, from the non-government sector. Taken together, the US in 2022 has experienced a twin tightening of monetary and fiscal policy not seen in nearly 50 years (see Figure 5 below). Such actions cannot be without effect. And the first-order direct impact is obviously on demand, in our view, meaning that demand deceleration is being changed into demand destruction.

Figure 5: Greatest twin tightening in the US since the late 1970s

Chart 5

Sources: Bloomberg and Macrobond, September 2022.

Looking forward, we believe central banks' rhetoric remains firmly in hawkish mode, underpinned by the continued rise of inflation through 2022 and emboldened by their focus on lagging indicators that signal an economic resilience that is likely to prove transitory. With inflation, by all measures so far above their targets, central banks have no escape clause from their intent to keep hiking rates, in our view.

Meanwhile, on fiscal policy, there is a rising chorus in some countries to alleviate cost of living stresses on households and businesses, but budget repair is still an inherent preference. Our fiscal process is to ask: Is it big enough, is it targeted enough, and is it sustained for long enough? We are not overly optimistic about probable answers to these questions. In the US, there could be even more fiscal cutbacks in the future if the November mid-term elections deliver a repeat of the divided government that caused the fiscal reversals after the 2010 mid-term elections, which led to an uninspiring decade-long economic expansion, in our view. Elsewhere, fiscal action seems to be largely focused on providing support or containment from the escalating cost of energy – which is not additive to demand. In the UK, for example, support measures were enacted that favoured tax cuts over direct spending, which will widen inequality by focusing on the wealthy, who have a lower propensity to spend. They will more likely end up boosting savings which ultimately are channelled into financial assets.


We think the evolution out of the current stagflationary environment will be determined by the interaction between the forces of supply recovery and demand deceleration. The rate of supply recovery will likely largely depend on geopolitical developments and efforts to expand capacity through fixed capital investment, factors that do not change quickly. Supply recovery – while set in motion – is unlikely to be big enough nor quick enough to dominate in coming quarters, in our view. Combined with demand deceleration, this means inflation is on the way down, but not likely to levels that will satisfy policymakers. With policymakers determined to use demand-side tools to control a supply-led inflation while relying on lagging indicators, we think a potentially benign demand deceleration will likely turn into demand destruction. We think the outlook will likely be determined by demand destruction overwhelming supply recovery.

This scenario will likely deliver the unintended consequence of a recession but without inflation coming down far enough – certainly not to traditional inflation target levels that would enable a pause in policy tightening. This means that the screws can keep turning (“the beatings will continue until morale improves!”) and the risk of a sharper-thanexpected recession will most likely be realised. Scenarios like this also serve up other unexpected nasty consequences such as financial crises (watching the UK closely) and social unrests.

In the longer term, we believe the path of supply recovery should likely converge to the rate of demand destruction. In fact, we think the recovery in capacity to supply goods and services could reach the point of delivering more than overall demand requires. In our view, this implies the rising likelihood not just of lower inflation during 2023, but also a period of cyclical deflation, perhaps as early as within the next one to two years. What this also means, in our view, is that a lot of proverbial dust needs to settle before the long-term structural themes, such as population and demographics, wealth and income inequality, and long-term productivity trends, reassert their fundamental influence on economies. For now, get ready to leave stagflation behind, but also get ready to land harder when touching down.


1Stagflation is characterised by above-trend inflation, accompanied by growth centred around zero. See Macquarie Fixed Income’s (MFI) September 2020 insight, which warned of negative supply shocks from the COVID-19 sudden stop leading to stagflation.

2 See MFI’s insight and its September 2021 Strategic Forum CIO note, where we emphasised the definition of transitory as an event-dependent condition, not necessarily a time-dependent condition. Once the severity of the event diminishes, the process of normalisation begins. Even on a time perspective, the stagflations on record have not sustained over a conventional business cycle.

3See the Insights paper, Assessing Inflation: Demand or Supply, What's the Real Problem, published in May 2022, where details of the assessment of demand were presented.

4Inflation has caused some confusion as it has enabled growth in nominal values but not necessarily real growth; this is why we focus on real terms, as do investors and policymakers who look at real gross domestic product (GDP) growth as a measure of economic prosperity.

5 See the section on Leading Indicators in the MFI Insight and Strategic forums for January and May 2022, which also presented a detailed examination of why demand is weakening

January 2022:

May 2022:


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