Friday, February 22, 2008

Stagflation Redux?

The latest inflation report from the BLS has generated some concern about "stagflation," an ugly artifact of the 1970's, making a comeback (can avocado appliances be far behind?). The word is a combination of "stagnation" (i.e. high unemployment and slow growth) and "inflation." We already knew that unemployment has been creeping up (4.9% in January, up from 4.4% last March). And now we learn that over the past 3 months, CPI inflation has been running at a 6.8% annual rate. Partly that reflects oil prices - just as 1970's inflation did - but the "core" CPI (i.e. with food and energy prices removed) has been increasing at a 3.1% annual rate. Ominous portents, but we have some distance to go before things look this bad:
(the red line is the unemployment rate, and the blue is CPI inflation)

One reason stagflation is so pernicious is that it puts the Fed in an awkward spot. High inflation requires the Fed to tighten monetary policy (i.e. raise the fed funds rate target), while the proper response to stagnation is to loosen. At Econbrowser, James Hamilton examines the numbers and the Fed's dilemma.

Paul Krugman believes the appropriate parallel is to early 1990's rather than the late 1970's. He writes:
...I don’t believe we’re really facing anything comparable to 1970s stagflation. For one thing, we’re less dependent on oil: America has more than twice the real G.D.P. it had in 1979, but consumes only slightly more oil. For another, there’s no sign of the wage-price spiral that once drove inflation into double digits — in fact, wage growth has been declining even as inflation rises.

What’s much more likely is that we’ll have an economy like that of the early 1990s, only worse.

The first President Bush presided over the 1990-1991 recession. But his real problem came during the alleged recovery, which was hobbled by financial problems at many banks, which had been badly damaged by the collapse of the late-1980s real estate bubble, and by sluggish consumer spending, held down by high levels of household debt.

As a result, the unemployment rate just kept rising, not reaching its peak of 7.8 percent until June 1992.

If all this sounds familiar, it should. Many economists have pointed out the parallels between the current situation and the early 1990s: another real estate bubble, subprime playing more or less the same role formerly played by bad loans by savings and loan institutions, financial trouble all around.

The difference is that the problems look a lot worse this time: a much bigger bubble, more financial distress, deeper consumer indebtedness — and sky-high oil prices added to the mix...
This Wall Street Journal article has some very informative background on stagflation, including:
British Parliamentarian Iain Macleod is credited with first using the word stagflation in 1965. "We now have the worst of both worlds -- not just inflation on the one side or stagnation on the other, but both of them together. We have a sort of 'stagflation' situation."

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