Not Stagflation

The WSJ had a cover page story about stagflation titled "Fears of Stagflation Return As Price Increases Gain Pace" {$$$}. The first three paragraphs sum the situation up nicely:

The U.S. faces an unwelcome combination of looming recession and persistent inflation that is reviving angst about stagflation, a condition not seen since the 1970s.

Inflation is rising. Yesterday the Labor Department said consumer prices in the U.S. jumped 0.4% in January and are up 4.3% over the past 12 months, near a 16-year high. Even stripping out sharply rising food and energy costs, prices rose 0.3% in January, driven by education, medical care, clothing and hotels. They are up by 2.5% from the previous year, a 10-month high.

The same day brought a reminder of possible recession. The Federal Reserve disclosed that its policy makers lowered their forecast for economic growth this year to between 1.3% and 2%, half a percentage point below the level of their previous forecast, in October. They blamed a further slowdown on the slump in housing prices, tighter lending standards and higher oil prices. They warned the economy's performance could fall short of even that lowered outlook.

The article continues on with a comparison between the economic environment of the 1970s and now. Some of the similarities are rising commodity prices, rising inflation, rising unemployment and slower economic growth. The commodities market has experienced record high prices on oil gold, corn, wheat and soybeans. The UBS Bloomberg Constant Maturity Commodity Index (an index of 26 raw materials) has increased 39 percent in the past year, compared to a 6.8 percent drop in the S&P 500 index. Consumer prices have increased 4.3% over the past 12 months and the Fed has reduced their economic growth outlook to 1.3% to 2%.

Currently the Fed is in a very tricky position trying to navigate between inflationary forces and a weakened economy. The Fed has reduced the Federal Funds Rate from 5.0% to 3.0% between June 2006 and January 2008 in order to spark an economic recovery and easy the liquidity crisis. The expectation is that the Fed will reduce rates again to 2.5% at the next Federal Open Market Committee's on March 18. Unfortunately the lower rates are increasing inflationary pressure without any increase in economic growth. Eventually the Fed will have to increase rates to keep inflation at an acceptable level.

Most likely we will avoid stagflation. However an argument can be made that we are in a period of "demi-stagflation" defined by Barry Ritholtz as a period of "anemic growth and robust inflation". This period has also been described as "stagflation light" .