Thursday, February 21, 2008

Fears of Stagflation Return As Price Increases Gain Pace

--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. --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. --The only generally agreed period of stagflation in the U.S. came in the 1970s. Its seeds were planted in the late 1960s, when President Johnson revved up growth with spending on the Vietnam War and his Great Society programs. Fed Chairman William McChesney Martin, meanwhile, failed to tighten monetary policy sufficiently to rein in that growth. --In the early 1970s, President Nixon, with the acquiescence of Fed Chairman Arthur Burns, tried to get inflation down by imposing controls on wage and price increases. The job became harder after the Arab oil embargo dramatically drove up energy prices, and overall inflation, in 1973. Mr. Burns persistently underestimated inflation pressure: In part, he did not realize the economy's potential growth rate had fallen, and that an influx of young, inexperienced baby boomers into the work force had made it harder to get unemployment down to early-1960s levels. --As a result, even when he raised rates, pushing the economy into a severe recession in 1974-75, inflation and unemployment didn't fall back to the levels of the previous decade. Mr. Burns and his colleagues wrongly concluded inflation no longer responded to the condition of the economy, said Ms. Romer, the Berkeley economist. "They didn't know how the world worked," she said.

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