Stagflation Equation May Not Add Up

The combination of apparent recession and skyrocketing commodity prices has a lot of people worried that a 1970s nightmare, stagflation, is making a comeback. But the deep unwind happening in credit markets suggests that the inflation part of stagflation will ultimately remain consigned to the attic, along with bell-bottom pants and disco balls. Recessions almost always throw cold water on inflation, making stagflation -- a combination of a weak economy and rising prices -- unlikely. That is what Federal Reserve officials will be betting when they slash interest rates again, as they are widely expected to do this month. "You get stagflation false signals in most recessions," says independent economist Robert Brusca, who points out that inflation has accelerated before or during every recession since 1961. In every case, inflation retreated as economic weakness hurt demand. Inflation kept reaccelerating in the 1970s because the Fed kept pumped money into the system too aggressively, a mistake officials say is burned into their memories. There is a strong argument that recession will weigh on inflation this time around. Homeowners, hedge funds and all manner of investors are suddenly being starved of the easy credit they long used to drive asset prices higher. A credit unwind is deflationary, not inflationary. Home prices have tumbled as banks have tightened lending standards. Hedge funds are holding fire sales on assets because banks are calling in loans. Stock prices are wobbling, too. The process has the potential to become self-feeding. Falling prices make debt burdens greater and reduce the value of collateral behind the debt. Borrowers thus try to shed their debt by selling more assets, driving prices lower still, making debt more painful, in a grim square dance that economist Irving Fisher called the debt-deflation spiral. An important wild card in all this is the weakening dollar. While a debt unwind is deflationary, a weakening currency is inflationary. It drives up the prices of imported goods. What happens when these two events happen simultaneously? Several Asian economies went through a similar process a decade ago. Mountains of debt in South Korea, Indonesia, Thailand and other economies crumbled in 1997, leading to waves of public- and private-sector defaults that punished their currencies. Inflation spiked temporarily. Indonesia's consumer prices rose 58% in 1998; economic output shrank 13%. Now that's stagflation. Yet within two years, Indonesia's currency had stabilized and consumer-price inflation slowed to 3.8%. Korea, Thailand and other Asian economies went through similar fluctuations. Korea's inflation rate spiked to 7.5% in 1998 and settled to 0.8% the next year. Could the U.S. repeat a version of this today? Well, the dollar has been weakening, and consumer prices are on the rise, with the CPI rising 4.3% in January. Still, if history is any guide, the Fed is making the right choice by focusing on recession -- and preventing a deflationary spiral that would make a recession seem like a day at the park -- rather than on a bout of inflation that might prove transitory.