Friday, June 10, 2022 01:40 PM
By Bloomberg: David Wilcox (Economist)

Inflation is running at the fastest rate in 40 years and growth is poised to slow. Understandably, many commentators are predicting that the US is doomed to suffer another bout of 1970s-style stagflation. They’re wrong.

The US experience in the late 1970s is the textbook example of stagflation. By the end of the decade — following two massive oil shocks, overly stimulative fiscal policy and ineffective monetary policy — PCE inflation was north of 11%. The gloom was palpable; inflation seemed set to continue at a high rate even though the economy wasn’t overheated.

The situation is different today. Yes, inflation is too high, but growth is far from stagnant and — crucially — the public remains confident the Fed will regain control of the situation over the longer term. For its part, the Fed is clear-eyed about its capabilities and responsibilities.

The distinction between then and now is of crucial importance for understanding the outlook. As long as the Fed retains public and market confidence, it will be much less costly — in terms of lost employment and output — to bring inflation under control. If the Fed loses the inflation anchor, the recession required to quell inflation will be much deeper.

The Fed understands these dynamics. That’s why Chair Jerome Powell regularly invokes the name of Paul Volcker, his predecessor from the 1980s. Powell has no intention of going down in history as the next Arthur Burns — the Fed chair who, more than anyone else, was responsible for the inflation catastrophe of the 1970s.

What Stagflation Is, and Is Not

Stagflation is the toxic combination of three ingredients: High inflation; expectations that inflation will remain high; and stagnant economic activity. Stagflation is high on any central banker’s list of nightmares because once it has taken hold, inflation can persist at a high level even though the economy isn’t overheated, and disinflation is much tougher to achieve.

All three ingredients are important:

Absent high inflation (and, presumably, the accompanying high expectations), all you’d have is an economy experiencing lackluster trend growth. Not great for the spread of prosperity, but not stagflation.

Remove high expectations from the picture and the high inflation will tend to moderate without the Fed having to crunch the economy. Inflation is partly a self-fulfilling prophesy, so if the conviction is widely held that inflation will eventually come down, it’s easier to attain.

Take stagnant activity out of the mix and maybe all you have is a classic case of an overheated economy causing too-high inflation. This is the best diagnosis of what we have today.

Stagflation is a chronic or structural economic affliction, not a passing infirmity. It means the economy isn’t temporarily weak because the Fed has decided it has no alternative but to cool an overheated economy. And it means that the condition is more than a momentary hiccup in the pace of economic activity or a blip in prices. It’s serious, and it’s protracted.

The Origins of 1970s Stagflation, and What We Have Today

The high inflation of the 1970s grew out of a combination of factors, including stimulative fiscal policy dating back to the mid-1960s, enormous oil price shocks in 1973 and 1979, and a couple of presidents who wanted inflation to be fixed on someone else’s watch. For its part, the Fed convinced itself that it wasn’t capable of bringing the situation under control.

Over the course of the decade, the public lost all confidence that the Fed would do the job, even over the medium term. By 1980, households expected inflation to average 9.6% over the next five years, and economic decision makers expected more than 8% over the next 10 years.

Today, inflation is high — though not as high as when Paul Volcker became Fed chair in 1979 — but in other respects the circumstances are starkly different. The situation today is problematic, but it’s not stagflation.

The economy today is anything but stagnant: The labor market is seriously overheated and needs to be cooled down.

The public remains confident the Fed will eventually regain control of the situation. Treasury market prices, consumer surveys, and professional forecasts all show it. The fact that confidence has not seriously been dented probably is due partly to the sudden emergence of today’s inflation over the past year, in contrast to the 15 years of mistakes that set the scene for Volcker.

Why the Stagflation Question is So Important

If the Fed can retain the public’s confidence, the job ahead will be much less difficult.

The economy overall — and the labor market in particular — are significantly overheated. The Fed is in the process of correcting that by tightening financial conditions. By design, that will cause GDP growth to slow and the unemployment rate to edge up.

Provided inflation expectations remain in check, that should essentially be the end of the story. With the excess heat taken out of the labor market and inflation expectations still well contained, actual inflation should subside most or all of the way back to the Fed’s 2% target.

However, if the Fed loses control of longer-term expectations, the plotline will become much more threatening. Cooling the labor market back to normal won’t be enough; high expected inflation will perpetuate high actual inflation. At that point, the Fed would have to induce a much deeper recession to wring inflation out of the economic system. To forestall this scenario, the Fed has adopted a much more hawkish tone of late. An ounce of prevention will be worth many pounds of cure.

Beware the Transition Period

One plausible scenario for the next couple of years would resemble stagflation, but wouldn’t be the real McCoy:

The Fed is in the process of clamping down on the economy. The labor market has remained strong until now but — if all goes according to the Fed’s plan — job growth eventually will slow and the unemployment rate will drift up.

Over time, the softer economy will result in lower inflation, but the process won’t be instantaneous. During a transition period, inflation will remain high even though growth is weak and unemployment is rising.

That transition period will not be pleasant but won’t qualify as stagflation. If all goes perfectly, the unemployment rate would remain below its long-run sustainable level throughout. There’s no guarantee the Fed will be able to pull it off, but this is the soft landing they’re aiming for.

The Job Ahead for the Fed

Powell & Co. are clear about their responsibility: They need to put inflation on a trajectory clearly headed back to the 2% target. Their task will be vastly easier if longer-term inflation expectations remain well anchored. Expect to hear much more about Paul Volcker in the months ahead.