How worried should we be? Federal Reserve Chairman Jerome Powell recently admitted it’s “frustrating” to have underestimated the bottlenecks causing this year’s spike in inflation. But he downplayed the lasting impact, questioning whether households will even notice the slightly higher inflation rates the Fed is now forecasting over the next two years once we’re past this year’s hump. Some economists, however, fear the U.S. could be headed for 1970s-style stagflation—a combination of high inflation, steep unemployment, and stagnant economic growth.“Periods where inflation is accelerating and economic growth is slowing, or stagnant, is a concern,” said Bryce Gill, an economist at First Trust Advisors. “It’s too early to say we’re heading back to the 1970s, but the Fed forecasts have severely underestimated inflation for the past year or so.” With inflation running at triple the rate it was at the start of the year and supply problems persisting, the Fed’s Federal Open Market Committee recently raised its 2021 inflation forecast to 4.2% from 3.4% and said inflation would run a little above 2% through at least 2024, which is as far out as it forecasts. While the 2022 forecast went up just a smidge, to 2.2%, the new rates were significantly higher than the committee’s December predictions of under 2% this year and next. Inflation, it’s important to note, isn’t always a bad thing. While it does eat into how far each of our dollars stretches for everything from gasoline and groceries to housing and furniture, some inflation is good, seen as a natural byproduct of a healthy, growing economy. The problem is when the economy isn’t growing that much—the “stagnant” part in stagflation—and inflation is still high.
The Fed’s Balancing Act
The Fed aims for somewhere around 2%, on average, and last year said it would shoot for a bit more than that for now, to help stimulate the economy. But now the inflation rate—4.3% as of August, according to the Fed’s favored measure—is more than double that Fed target, while unemployment remains higher than before the pandemic, and other signs, like weakening consumer confidence amid a summer resurgence in daily COVID-19 cases, point to slowing economic growth.This combination puts the Fed into a tight spot: normally the central bank keeps price hikes in check by raising benchmark interest rates, but doing that too soon or too much risks dampening consumer spending, slowing the economy down further and pushing unemployment higher. “It has been decades since the Fed has had to chase inflation,” wrote Diane Swonk, chief economist at Grant Thornton, in a commentary. “The risk is that the Fed accidentally tips the economy into another recession before we have fully healed from the last.” Indeed, prominent economists like Nouriel Roubini, former economic adviser during the Clinton administration, have been sounding the alarm about this danger for months. “A variety of persistent negative supply shocks could turn today’s mild stagflation into a severe case,” he wrote in September. What’s more, oil prices have climbed to their highest levels since 2014, reminding some of the steep prolonged spike in prices in the 1970s, which dragged on the economy.
A Different Situation
Under normal circumstances, high inflation results from an overheating economy in which people are flush with cash and spending so freely that supply can’t keep up with demand. The Fed may respond by tightening the money supply—through a higher benchmark interest rate, for example—so people don’t have such easy access to cash. That normally would slow down demand and allow supply to catch up, putting the economy back into equilibrium. But this time around, things are different. While the Fed can influence demand, it generally can’t do much to ease supply disruptions. Recent inflation “is a function of supply-side bottlenecks, over which we have no control,” Fed Chairman Jerome Powell told Congress late last month. Factory shutdowns, shipping delays, and worker and material shortages continue to snarl the supply chain—and are expected to continue at least through year’s end. At the onset of the COVID-19 pandemic last year, the Fed quickly slashed its benchmark fed funds rate to near zero and embarked on a massive monthly bond-buying program to ensure people could easily get money and continue to spend and the economy wouldn’t seize up. When the first wave of COVID-19 waned in the summer of 2020 and businesses started to reopen following lockdowns, the trajectory for the economy looked bright. Armed with extra income from stimulus checks, households suddenly had places to spend again. The recovery had ups and downs as COVID-19 cases ebbed and flowed, but vaccine rollouts in the new year boosted optimism. Through it all, consumer prices rose, but Powell was adamant that any high levels of inflation would be “transitory,” or temporary, and stock and bond markets were seemingly convinced. Stocks climbed to record highs throughout the summer, and 10-year Treasury yields—a reliable indicator of home mortgage rates, for example—mostly hovered below 1.4%. All that made sense—until the fast-spreading delta variant of the virus emerged over the summer, putting the brakes on economic activity yet again. Third-quarter GDP growth is now expected to be just 1.3%, according to the latest Oct. 8 estimate from the Atlanta Fed’s GDPNow tracker, down from 3.7% just a month ago. Meanwhile, even as forecasts for economic growth have been slashed, prices have stayed elevated—as did expectations for them to continue rising. A New York Federal Reserve survey in September showed consumers haven’t braced themselves for higher inflation rates in the seven years the survey has been taken.
Inflation Narrative ‘Is Wrong’
The increase in the Fed’s favored measure—the personal consumption expenditures (PCE) price index—in the 12 months through August was the highest year-over-year jump seen since 1991, even when you strip out the more volatile food and energy prices to get the so-called core rate. (It’s 4.3% or 3.6%, depending.) Put another way, “The last time inflation was this high, Cheers was still on TV on Thursday nights,” noted Wells Fargo economists Tim Quinlan and Shannon Seery in a recent commentary. The other widely used inflation measure, the Consumer Price Index, or CPI, showed prices increased 5.3% in the 12 months through August, just slightly less than in June and July, when the year-over-year jump was at a 13-year high of 5.4%. Excluding food and energy, however, price increases decelerated for a second straight month to 4.0%, suggesting to some that inflation rates have passed their peak. But many other economists, including Atlanta Fed President Raphael Bostic, warn inflation pressures are far from over, particularly as a labor shortage fuels higher wages and housing prices continue to soar. “Count us as firmly in the less-calm camp,” Douglas Porter, chief economist for BMO Capital Markets, wrote in a recent commentary. “We view this not as the beginning of the end of the inflation risk, but more like the end of the beginning.” Because central bankers have the power to keep inflation in check with interest rate increases and other tightening of the money supply, how much of a threat they see inflation having on the economy is critical. The Fed, set to have its next policy meeting in early November, walks a tightrope, balancing the risk of inflation spiraling out of control with fulfilling its other mandate, keeping the country employed. For the past two months the economy has added fewer jobs than expected, with September adding just 194,000—the smallest monthly gain this year. That could make any move by the Fed to tighten the money supply, such as paring back its asset purchases, much riskier. While Powell continues to say that the higher inflation should be transitory and supply constraints will abate, he admitted at a recent central bankers’ forum that it’s “frustrating to see the bottlenecks and supply chain problems not getting better—in fact, at the margin, apparently getting a little bit worse. And we see that continuing into next year probably and holding inflation up longer than we had thought.” Clearly, not everyone is reassured. Since the central bank’s Federal Open Market Committee released its updated inflation projections on Sept. 22, 10-year Treasury yields have risen sharply, and stocks have retreated from their peaks. On Tuesday, Treasury data showed the 10-year yield at 1.59%, up from 1.32% on Sept. 22. The broad Standard & Poor’s 500 index was down more than 4% from its record on Sept. 2, and the tech-heavy Nasdaq was 6% off its record on Sept. 7. The Dow Jones Industrial Average also shed 3.5% from its record on Aug. 16. “The Fed’s transitory narrative on inflation is wrong and inflation will continue to overshoot expectations through much of the next 12 months as it has done for most of this year,” James Knightley, chief international economist at ING, wrote in an email.
Reasons for Optimism
To be sure, the stagflation scenario depends on how hard and how lasting any economic slump might be. The last time the U.S. experienced a long period of stagflation was during the 1970s, when the economy suffered through several recessions and an oil embargo and inflation rose by double digits. Although the economy has taken a hit as the delta variant of COVID-19 spread and supply bottlenecks worsened, the Fed and many economists still expect GDP growth of over 3% next year—a typical healthy rate pre-pandemic. “Stagflation is an important word that shouldn’t be thrown out without caution,” said Gregory Daco, chief U.S. economist at Oxford Economics. “Stagflation is no or very slow growth and inflation, not a modest slowdown. The economy is still moving at a fairly fast clip.” Indeed, the daily count of U.S. COVID-19 cases is falling again, adding to optimism that setbacks from the summer may be short-lived. “COVID cases appear to be sliding and with incomes looking very healthy and today’s household wealth figures looking very robust, there is plenty of cash ammunition to keep consumer spending strong, so I continue to be very upbeat on 2022,” said ING’s Knightley. He added that if the Biden administration manages to pass its infrastructure spending bill with most of the social spending intact, he expects GDP growth of at least 4.5% next year. First Trust’s Gill, however, said one of his biggest concerns remains what he calls the “COVID rollercoaster,” which can cause the economy to grow in fits and starts. “Whenever a new variant emerges and we see a surge in cases, not even deaths, half of the states push ahead and others maybe won’t lock down, but will put in restrictions again,” he said. “That could be an impediment, keeping people out of the labor force, moms staying home to watch kids as schools shut down. The headwinds we thought were gone don’t seem to be disappearing.” Have a question, comment, or story to share? You can reach Medora at medoralee@thebalance.com.
