The Return of Stagflation?

Today's Wall Street Journal looks at the possible return of "stagflation" to the U.S. economy, an economic malaise that combines recessionary unemployment with rampant inflation:

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....

A simultaneous rise in unemployment and inflation poses a dilemma for Fed Chairman Ben Bernanke. When the Fed wants to fight unemployment, it lowers interest rates. When it wants to damp inflation, it raises them. It's impossible to do both at the same time.

Stagflation, a term coined in the United Kingdom in 1965, defined the years from 1970 to 1981 in the U.S. Inflation rose to almost 15%. The economy went through three recessions. Unemployment reached 9%. Fed Chairman Paul Volcker finally conquered inflation, but only by dramatically boosting interest rates, causing a severe recession in 1981-82.

Today's circumstances are far from that. Inflation is lower. Unemployment has risen, but only to 4.9%.

Yet there are similarities. As in the 1970s, surging commodity prices are leading the way. Crude oil rose to $100.74 a barrel yesterday, a new nominal high and close to its 1980 inflation-adjusted high. Wheat prices have hit a record. And, as in the 1970s, the rate at which the U.S. economy can grow without generating inflation has fallen, because of slower growth in both the labor force and in productivity, or output per hour of work.

The biggest difference is that in the 1970s, the Fed was unwilling, or thought itself unable, to bring inflation down. The Fed today sees achieving low inflation as its primary mission.

I also think we have much more flexible labor markets in the U.S. today, and we've not faced the same type of cost-push price increases associated the inflationary oil shocks of the 1970s.

That said, recent actions of the Federal Reserve have looked increasingly desperate in trying provide some liquidity to the financial system.

I've been bullish on the economy since the beginning of the subprime collapse. Unemployment still at historically low levels, for example, although housing's still freefalling to some extent, so it remains to be seen if this year dodges the bullet on a full-blown economic collapse.