Stagflation: Real Threat or Imagined?
The issue of stagflation and the Federal Reserve’s likely response have become headline news on Wall Street and Main Street. The Federal Reserve policy making committee does not meet until March 15. Until that time, market participants, economic observers and average citizens alike are speculating on the Fed’s next move.
While not a prediction of what will happen next, it might be helpful to review the last bout of stagflation that the U.S. endured to understand the challenge the Fed faces now. The last major stagflation period in the U.S. lasted from 1965 until 1982. In 1964 inflation was roughly 1 percent and unemployment was 5 percent. Ten years later, inflation was over 12 percent and unemployment was above 7 percent. Known as the Great Inflation, it was only ended by the tenacity and determination of Former Federal Reserve Chair Paul Volcker and required a very deep recession. Economists see four causes of the Great Inflation, which have some similarities with the economic developments that we are experiencing today but also some very important differences.
First, fiscal and monetary policy were both stimulative for a long period in the early 1960s, reflecting a desire by the Federal government to foster permanently lower unemployment by allowing a rise in inflation and by President Lyndon Johnson’s policy of both social safety next expansion and prosecuting the Vietnam War without raising taxes. We similarly today have had a period of stimulative fiscal and monetary policy. However, there is an important difference, which is that fiscal stimulus is quickly reversing as the emergency measures from the fight against the COVID-induced recession is unwound and as President Joe Biden is forced to limit his policy aspirations by a Congress that is less inclined to spend. Monetary policy is certainly likely to become less stimulative, but the Fed is not attempting to create overly tight financial conditions and will calibrate its moves carefully with due regard to emerging risks.
Second, the economy in the 1970s suffered two supply side shocks that resulted in higher consumer prices: the Oil Shocks of 1973 and 1979. Similarly, we are experiencing price increases that are emanating from global oil markets. We do not know how long the oil price increases resulting from the Russian invasion of Ukraine will last. However, the Oil Shocks of the Great Inflation far outstrip anything that we have experienced to date. During the Great Inflation, crude oil prices quadrupled during the 1973 crisis, plateaued, and then doubled again during the 1979 episode. The oil price increases that we are experiencing are not yet of this magnitude. The other supply side challenges we confront today are driven not by politics primarily but by market dynamics—although the efforts to isolate Russia will make the supply chain issues more challenging. At base, however, the supply chain challenges are result of the inevitable unevenness in opening the global economy after the pandemic induced closures—and will certainly over time lessen as the market signal and business incentives are aligned to resolve the supply issue, although not as quickly as some observers had hoped when they described inflation as “transitory”. However, we face one supply side concern that was not present in the 1965-1982 period. Namely, we have an unexpected decline in labor force participation at the same time as these other supply constraints, which is driving up wages and overall compensation in numerous jobs, from blue collar work to Wall Street bonuses. The labor force challenge, and the possibility of a spiraling of wages and prices ever higher, must be a major concern for the Fed.
The third cause of the stagflation of the 1965-1982 period was the absence of internal or external constraint on how much inflation the Fed could tolerate. Until 1972, high and rising inflation resulted in a draining of America’s gold reserves, a major challenge that put some pressure on the U.S. government to respond. When Richard Nixon decided in 1972 to take the U.S. off the gold standard that had been imposed since World War II by the Bretton Woods system, inflation could be allowed to run even hotter with no clear and immediate repercussions for national financial standing. Currently, the Fed has tied its hands by adopting an inflation target of roughly 2 percent, creating an external standard of satisfactory inflation performance. However, the Fed recently slightly altered its message on its inflation target by indicating that it will allow inflation to rise somewhat above 2 percent for an undetermined, but presumably short, period to make up for past shortfalls in inflation below the 2 percent target. The Fed also indicated that it seeks broadly inclusive growth, suggesting to some that it is putting greater weight on labor force variables, such as labor force participation rates for women and minorities who have not participated fully in the long expansion of the past 20 years. The move toward greater flexibility in inflation targeting was the result of a very thorough review, but it was introduced at a time of unexpected inflation developments and could potentially have been seen as reducing, if only moderately, the Fed’s commitment to the 2 percent target.
Finally, the long period of upward price movements accommodated by the Fed in the 1960s and 1970s is widely seen today to have reduced the Fed’s credibility during that period and increased inflation expectations among business leaders and workers alike, creating a condition in which a wage-price spiral emerged. Today, most fair observers recognize that the Fed maintains ample credibility, although many would argue that the credibility must be reinforced by an effective response to the recent sharp rise in measured inflation. However, a recent survey of CEOs does give some early concern that perhaps inflation expectations are rising. Most CEOs surveyed, roughly 75 percent believe that it might be harder for the Fed to rein in inflation than is usual, given the push of both wages and other input costs impacted by supply difficulties. Additionally, most CEOs expect to pass along wage and input costs within a year, suggesting very little push back from customers or end consumers, i.e., an increase in inflation expectations.
The Federal Reserve and the global economy are confronting major challenges, only exacerbated by the response to the Russian invasion of Ukraine. Given the similarities and differences between the 1965-1982 period and now, the recent fear of stagflation is legitimate, but seems overstated. The Fed, the economics profession, and the population in general have all learned much from that experience of the 1960s and 1970s and the painful recession that it took to eradicate inflationary pressures that had built over many years. Even the challenges that are like those we faced in the earlier episode of stagflation—oil market dynamics—are not as severe. However, understanding both the similarities and differences from that unpleasant experience must certainly be instructive as the Fed navigates this new set of challenges.