Commentary - Stagflation
Stagflation is becoming a vogue in business journalism. Just try googling the term and see for yourself. I wonder why, and why at this particular juncture? Perhaps business journalists are just plain tired of reporting sensational, soap-operatic business scandals like Enron, Arthur Anderson, Worldcom, Nigerian barge, SPEs, off-balance sheet items, Jack Grubman, Henry Bloget, mutual fund timing, after-hours trading, AIG, finite-insurance product etc. etc. etc. Perhaps they want to be taken seriously by the public. What is a better way for journalists to elevated themselves than to jibe about the economy and duel with Chairman Greenspan at his own game? No less authority than the Economists has delved into that debate. For serious followers of the economy, the Economist's conclusions were not very surprising. It argued that a return to classic stagflation is unlikely because productivity growth is going to continue and wage growth is going to remain mute which will produce robust growth with no inflation.
The Economists is right in that there are two components to stagflation, a prolonged period of "below potential economic growth and above trend inflation". Duh! That is the definition! The classic example obviously is the U.S. experience during the 1970s. There is a whole literature on that subject but the basic conclusions (I think) for the stagflation in the 1970s were a combination of bad economic policies and demand shock. Economic policy in the early 1970s had to deal with the immense imbalances created in the 1960s by the Vietnam War and the Great Society Program vis-à-vis rising inflation, declining economic growth, and foreigners holding tons of gold which they could repatriate to the U.S. at $35 an ounce exasperating inflationary pressure. President Nixon decided to deal with them all - inflation, economic slowdown, and foreign imbalances -
at once in the summer of 1971 by ordering wage and price freeze and closing the "gold window" effectively taking the U.S. out of the gold standard. Meanwhile, the Fed under Arthur Burns kept the monetary policy loose. Some conspiracy theorists suggest that Nixon and Burns had a deal prior to the 1972 election but there is no veracity to that. Such drastic fiscal and monetary policies achieved the economic goals but did not solve the underlying problem; rather they only postponed them until the oil price shock couple of years later. Oil prices jumped from $4.3/barrel in December 1973 to $10.1/barrel in January 1974 because the OPEC countries placed embargo on the U.S. and other western countries that supported Israel during the Yom Kippur War (6 October 1973 -23 October 1973). The oil price shock pushed up inflation and lowered economic growth. The Fed's tightened monetary policy to curtail inflation but inflation only budged a little but the economy went into a tail-spin. The Fed made a U-turn in policy within a year to reverse the economic decline. Economy did pickup but inflation picked up even more. The Fed fell "behind the curve" and spent the entire late 1970s trying reverse the policy mistake that created the inflationary pressure.
The Economist article argues that the current situation does not warrant a comparison to the 1970s. I beg to differ somewhat because I see many ominous similarities. The fiscal policy today is a mess. Irresponsible tax cuts and uncontrolled spending has worsened the structural imbalance in the federal budget when the administration should have been doing the opposite given the demographic onslaught that is certain to occur starting 2011. Monetary policy is not that great either despite legions of Greenspan’s fans in the financial markets because it is excessively loose for this time in the cycle. The Fed is pumping so money so fast into the system that the U.S. real estate speculators, emerging market investors, and junk bonds purveyors don' t know what to do with all the money other than to pump up the prices. Normally, too much dollar in the market should have caused it to depreciate. Well it has but not as much as it should because Asian countries are hoarding them in the form of U.S. securities. China alone bought $16 billion worth of U.S. stock and bonds in February 2005.
The only dissimilarity with the 1970s is that inflation remains contained. Fed is taking comfort in the fact that inflation expectation is anchored around 3.0%. But the Fed better not be complacent because inflation is already creeping up. The core inflation is exhibiting momentum not seen in several years. Moreover consumers could readjust their inflation expectation fairly quickly. Of course the Fed has said it is vigilant about inflation in its most recent FOMC statement. But the Fed’s view on inflation is influenced by, like the Economist magazine, its strong belief in continuing growth in productivity. That explains the Fed’s slowness in normalizing the rates. The Fed knows that productivity growth is decelerating but it thinks that it is a cyclical phenomenon and not the beginning of a sustained decline. We hope the Fed is right.
The Economists is right in that there are two components to stagflation, a prolonged period of "below potential economic growth and above trend inflation". Duh! That is the definition! The classic example obviously is the U.S. experience during the 1970s. There is a whole literature on that subject but the basic conclusions (I think) for the stagflation in the 1970s were a combination of bad economic policies and demand shock. Economic policy in the early 1970s had to deal with the immense imbalances created in the 1960s by the Vietnam War and the Great Society Program vis-à-vis rising inflation, declining economic growth, and foreigners holding tons of gold which they could repatriate to the U.S. at $35 an ounce exasperating inflationary pressure. President Nixon decided to deal with them all - inflation, economic slowdown, and foreign imbalances -
at once in the summer of 1971 by ordering wage and price freeze and closing the "gold window" effectively taking the U.S. out of the gold standard. Meanwhile, the Fed under Arthur Burns kept the monetary policy loose. Some conspiracy theorists suggest that Nixon and Burns had a deal prior to the 1972 election but there is no veracity to that. Such drastic fiscal and monetary policies achieved the economic goals but did not solve the underlying problem; rather they only postponed them until the oil price shock couple of years later. Oil prices jumped from $4.3/barrel in December 1973 to $10.1/barrel in January 1974 because the OPEC countries placed embargo on the U.S. and other western countries that supported Israel during the Yom Kippur War (6 October 1973 -23 October 1973). The oil price shock pushed up inflation and lowered economic growth. The Fed's tightened monetary policy to curtail inflation but inflation only budged a little but the economy went into a tail-spin. The Fed made a U-turn in policy within a year to reverse the economic decline. Economy did pickup but inflation picked up even more. The Fed fell "behind the curve" and spent the entire late 1970s trying reverse the policy mistake that created the inflationary pressure.
The Economist article argues that the current situation does not warrant a comparison to the 1970s. I beg to differ somewhat because I see many ominous similarities. The fiscal policy today is a mess. Irresponsible tax cuts and uncontrolled spending has worsened the structural imbalance in the federal budget when the administration should have been doing the opposite given the demographic onslaught that is certain to occur starting 2011. Monetary policy is not that great either despite legions of Greenspan’s fans in the financial markets because it is excessively loose for this time in the cycle. The Fed is pumping so money so fast into the system that the U.S. real estate speculators, emerging market investors, and junk bonds purveyors don' t know what to do with all the money other than to pump up the prices. Normally, too much dollar in the market should have caused it to depreciate. Well it has but not as much as it should because Asian countries are hoarding them in the form of U.S. securities. China alone bought $16 billion worth of U.S. stock and bonds in February 2005.
The only dissimilarity with the 1970s is that inflation remains contained. Fed is taking comfort in the fact that inflation expectation is anchored around 3.0%. But the Fed better not be complacent because inflation is already creeping up. The core inflation is exhibiting momentum not seen in several years. Moreover consumers could readjust their inflation expectation fairly quickly. Of course the Fed has said it is vigilant about inflation in its most recent FOMC statement. But the Fed’s view on inflation is influenced by, like the Economist magazine, its strong belief in continuing growth in productivity. That explains the Fed’s slowness in normalizing the rates. The Fed knows that productivity growth is decelerating but it thinks that it is a cyclical phenomenon and not the beginning of a sustained decline. We hope the Fed is right.
posted by The Poster | 11:02 PM
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