No Stagflation Nation

Story Highlights

• Stagflation is once again making its way into headlines in the US.
• Stagflation requires two things: Slow or declining economic growth coupled with high inflation—and the US has neither.
• Economic growth has only slightly slowed for one quarter—before that, GDP growth was strong for several consecutive quarters.
• High unemployment, low capacity utilization, and lack of lending have kept inflation in check—if inflation does become a threat, the Fed has a few things it can do to rein it in.

In the wake of slower-than-expected GDP growth coupled with rising oil and food prices, stagflation warnings are once again being rehashed in the US. But note, to get to “stagflation” (a word with no official definition, by the way), you’d need two things: Very low or declining GDP growth plus high inflation. And currently, we have neither.

Prior to Q1’s slower 1.8%annual GDP growth (still growth, mind you), Q4 2010 came in at a strong 3.1%—and as we’ve said, GDP can slow and speed from quarter to quarter, and that’s totally normal in a growth cycle. Plus, one slower quarter of growth doesn’t necessarily portend a less bright outlook, and indeed Q1 corporate earnings are currently soundly beating expectations.

As for inflation, while it has somewhat trended upward recently, it is still extremely tame relative to the late 1970s—when “stagflation” last actually took hold. It can be instructive to think of inflation as too much money chasing too few goods and services. A little bit of inflation is good—it helps drive the economy forward—but high inflation suggests excess liquidity. With this definition, however, it’s easy to see some inflation-containing forces in today’s environment.

Let’s consider goods and services. While high unemployment isn’t a blessing, it can be a price-muting force—more workers than jobs limit upward wage pressures. This is a situation completely different from the 1970s and early 1980s, when the average hourly pay rose 7.3% in 1977. In contrast, hourly pay rose an average of 1.9% in 2010. Additionally, capacity utilization remains below a level where firms can pass along higher input costs. Taken together, it seems neither the goods nor services end of our economy has such tight production conditions to meet the “finite” amount description.

While easy monetary policy has added liquidity to the economy, the majority of the money created sits in the form of excess bank reserves. Those reserves aren’t inflationary in and of themselves—remember, the money must actively chase goods and services to be inflationary. Bank lending has yet to pick up significantly, meaning the money created by the Fed still has to work its way through the economy—though factors like higher lending standards, increased risk aversion, and higher capital requirements could curtail some of that.

Yes, it’s true inflation has ticked up lately. But when the cost of food and energy (gas, oil, etc.) is stripped away, core CPI only rose 1.2% y/y in March. Contrast that with core CPI rising an average of 10.9% annually from 1979 to 1981and CPI rising over 11.7% per year on average back then. Even if you include food and energy, inflation currently is far from those levels.

If inflation pressures become more evident, the Fed has plenty of tools at its disposal to reduce the money supply to rein in inflation, including raising rates. With rates near zero now, the Fed has room to adjust accordingly. True, the Fed’s track record is far from perfect in dealing with inflation in the past. But fearing inflation when inflation statistics don’t show it amounts to preparing in advance for monetary mistakes not yet made.

Simply, stories and fears of stagflation may abound, but when one looks at facts, economic growth and very low inflation don’t seem to match our understanding of stagflation.