Investors fear with good reason that out-of-control inflation will trigger a recession, as I warned in a June 19 analysis (“Fed starts to signal recession fears”).

Inflation almost always leads to recession, because it destroys consumer budgets and corporate profit margins. Except for the mild 1990 recession, every US economic downturn in the past fifty years began with an inflationary squeeze on profit margins.

The usual suspects in the financial press are blaming Monday’s rout on the spread of the Delta variant of Covid-19. But the three-day average of new Covid cases in the US as of July 18 was below 25,000, less than a tenth of the January 8 peak of over 300,000.

The chart below shows the difference between changes in prices paid by businesses and prices received (the percentage of businesses reporting higher prices paid minus the percentage reporting higher prices received), as reported by the monthly survey of the Philadelphia Federal Reserve. Several other Fed districts conduct similar surveys with nearly identical results, but the Philadelphia data go back fifty years, and track national business surveys most accurately.

The gap between what business pays for inputs and what they are able to charge for finished products is the most consistent recession signal I know.

Inflation, to be sure, batters consumers as well as businesses. It is an insidious tax that reduces real wages for hourly workers as it force-feeds the middle class into higher tax brackets and raises the average tax rate on households.

There are already signs that consumers are pushing back. Despite $5 trillion worth of stimulus checks to US households, retail sales have come in weak during the past two months as hourly earnings fell after adjustment for inflation.

It is far from clear whether the inflation surge will lead to a recession – and, if so, when. But it could do substantial damage to a stock market now trading at 30 times trailing earnings, equal to the peak of the 1999 bubble.

The most likely outcome is not an actual recession—not as long as the Federal Reserve continues to buy $80 billion in Treasury securities each month and to keep short-term rates at zero – but a sort of stagflation, with persistent price increases of 5% or more and weak growth.