Sunday, June 22, 2008

Stagflation: a figment of America’s imagination

We are not returning to the infamous Stagflation era of the 1970’s and 1980’s. Sure, it feels like the energy crisis is plowing through the economy, but the data shows that inflation is contained, and if the energy markets stabilize, the prices for most goods will not rise at all. Actually, Stagflation never really occurred in the 1970’s nor in the 1980’s.

Previous to the recession of 1973-1975, inflation was at uncomfortably high levels following a decade of strong growth in the 1960’s. The Fed started to raise interest rates in order to contain inflation, and when the oil shock of 1973 hit, the Fed did not lower interest rates enough to combat rising unemployment and falling income. The combination of high inflation and negative growth (what would be called stagflation) was not really stagflation at all, and just bad policy on the part of the Fed. Previous to the recessions of 1980 and 1981-1982, inflation was still at uncomfortably high levels, and the second energy shock hit in 1979. In his famous era of disinflation, or lowering of inflation rates, Paul Volcker raised interest rates that caused a recession, but inflation fell drastically. Again, there was no stagflation, but simply high inflation (that was falling) and low growth derived from Fed policy. We are one step ahead this time around. When the energy shock occurred, and the real price of oil (price without inflation) has exceeded that from the 1970’s and 1980’s, the U.S. was experiencing the great era of disinflation: 15 years of low inflation.

  • The Fed is starting from a point of low inflation, and can help the economy through rising unemployment and falling income. So, since growth is still very positive, we will not see rising prices and falling growth (the definition of stagflation) as the Fed was able to drop interest rates to fuel the economy.

A bit on inflation

First, inflation (the percentage-change in prices each year) is a natural process. The Fed prints money each year, and inflation is always greater than zero. Consumers are used to rising prices, but rising too quickly is a bad thing.

Second, there are two common measures of inflation. Headline inflation is the annual percentage-change in prices for all goods. Core inflation is the annual percentage-change of prices for all goods except food and energy. Food and energy prices often fluctuate quickly, and their price changes are usually short-lived. The central bank of the United States, the Federal Reserve Bank (Fed), usually tries to control core prices since they are better stabilized by standard monetary policy (changing interest rates).

As the graph illustrates, recently headline inflation sits above core inflation, but in the ‘70s and ‘80s, core inflation was above headline inflation. This time around (2008), food and energy prices are rising faster than the prices of other goods. The most recent headline inflation was 4.2%, while core inflation was just 2.3%, and core inflation remained essentially unchanged for four months. Simply put: only food and energy prices are really on the rise.

As long as food and energy prices stabilize (stop rising) before firms start charging higher prices for all goods, then headline inflation and core inflation will soon be the same, and the inflation threat will be history.

As I mentioned in a previous blog, energy prices are set to stabilize, or even fall, with reduced global demand for oil. This means that we will not see inflation, headline or core, hitting double digits (12%) like it did in the 1970’s and 1980’s. Don’t worry, stagflation will not emerge. The Fed will not allow prices to rise indiscriminately.

I appreciate your comments or suggestions. Best, Nontruths

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