Stagflation – a blast from the past could mean trouble for US economy

Inflation gets a new focus along with recession worries – Feb. 21, 2008
As we begin our studies of the theories underlying the aggregate demand/aggregate supply model in AP Macroeconomics, it is useful to look in the news to see if we can try and understand how these theories apply to the real world. In the US, it appears as if a dangerous economic phenomena that plagued the country in the early 1970′s may be returning to wreak its havoc among households and policymakers.
Stagflation, “the unwanted combination of stagnant economic growth and destructive inflation”, has emerged in America today, in the face of weak aggregate demand and rising unemployment, combined with rising costs to firms thanks to energy costs and food prices.

Recession has been getting so much attention lately that it’s been easy to forget about the threats posed to the U.S. economy by inflation.But inflation worries are now back in focus in a major way. Oil prices hit a record of $101.32 a barrel in trading Wednesday, and was briefly above $100 again Thursday
Meanwhile, the Consumer Price Index, the government’s key inflation reading, showed a 4.3% rise in overall prices over the past 12-months. That reading has risen steadily from only 2.0% last August. Even stripping out volatile food and energy prices, the so-called core CPI posted the biggest seasonally-adjusted one-month jump in 19 months.

Typically inflation is experienced during the expansion phase of the business cycle, and is accompanied by falling rates of unemployment and increases in output, both positives for the economy as a whole. This type of inflation presents policy makers with clear solutions: reign in aggregate demand through contractionary fiscal and monetary tools, slow the rate of expansion, and stabilize prices.
The inflation that presents policy makers with a greater challenge, however, is that experienced by America today, which is cost-push in nature. Combined with weak aggregate demand, the Federal Reserve and the government’s hands are tied when it comes to intervening to restore price level stability. Traditional contractionary methods like raising taxes and interest rates will exacerbate the weak aggregate demand as households and firms reduce their spending. This will worsen the “stagnation” (low to negative growth) the economy has experienced over the last couple of quarters, and will not solve the problem of rising production costs, which are rooted in exogenous factors like energy and food prices.
Apparently, the Fed, in deciding to cut interest rates by 1.25% in the last two months, failed to consider the inflationary effect this may have:

Typically, slower growth or an actual recession cuts demand for products enough to curb prices. Based on the minutes from the Fed’s latest meetings, that seems to be what the Fed is banking on to keep inflation under control…
David Rosenberg, the chief North American economist for Merrill Lynch, wrote in a note Thursday that inflation should not be a major worry. Rosenberg is one of a growing list of economists who believe a recession has already begun.
He argued that commodity prices have only a limited impact on the cost of final goods and that wage growth is a bigger contributor to inflation. A weak job market should keep wages from rising sharply.

In other words, as the US enters a recession and unemployment increases, wages will cease to increase and may even fall. The fall in wages will lower firms costs, shift aggregate supply outward, and reduce the threat of inflation. But in today’s global economy, factors besides domestic wages, such as the weakening dollar and growing demand for America’s output from abroad, must be considered when considering inflation risks:

The weakening dollar is a concern since it raises the price of dollar-denominated commodities, such as oil and other raw materials, as well as imported goods…
Ritholtz said that overseas demand from growing markets such as China and India are likely to keep prices for many goods high, even if consumption of those products falls in the United States.
“Unless we see a significant U.S. recession that causes a slowdown overseas, inflation may be stickier this time around,” he said.

Once again we are witnessing the complex interactions of the world’s economies in play. Stagnant growth in the US combined with a weak dollar may lead to a slowdown of growth in China, which depends on US consumers as a destination for its exports. Ironically, if the US is to avoid stagflation, one of the most challenging macroeconomic problems to fix, it may just depend on a slowdown in growth of aggregate demand in China, which consumes not just an ever-growing proportion of the world’s raw materials, but a growing proportion of America’s own output as well. A slowdown in China would relieve pressure on input prices of raw materials, and reduce US export demand, dampening both the demand and supply side inflationary pressures in the US.
For a graphical portrayal of stagflation using the aggregate demand/aggregate supply model of the macroeconomy, click on the graph above.