Is the American Economy Heading for Stagflation?

There are more and more signs that the Obama recession is taking a turn for the worse. Last week I reported that

…year-to-year inflation-adjusted growth is down. In the first quarter of 2011 the U.S. economy grew by 2.2 percent over the first quarter of 2010. In Q1 of 2012 the year-to-year growth rate is 2.1 percent. If Obama’s recovery policy had worked and put us on a traditional recovery path, we should have at 3+ percent growth by now. We are at the very least one full percentage point below where we should be, provided again that we were on a recovery path. Since the GDP growth rate has actually slowed down marginally, we now have yet another round of GDP data that confirms the utter failure of the Obama administration’s anti-recession policies.

Today we add another piece of evidence to the indictment of Obamanomics: the prospect of stagflation. A series of recent reports by the Bureau of Labor Statistics on regional inflation show disturbing signs of rising inflation, in the midst of an economic slowdown.

Stagflation means two things:

  • high inflation and high unemployment; and
  • inflation is higher than real GDP growth.

Traditional macroeconomic textbooks teach the first part, but the second part is often overlooked as a stagflation “red flag”. Yet it is one of the most important indicators of the health of the economy as well as of the looming threat of stagflation. And based on the newest GDP numbers and inflation figures, we could be seeing the very first signs of stagflation in the U.S. economy.

The indicator used here is very simple. GDP growth is measured in two ways:  current prices and inflation-adjusted. Current-price GDP growth is the addition of real growth and inflation. If real GDP grows at three percent and inflation is two percent, current-price GDP growth is obviously five percent.

What matters is the relation between real GDP growth and inflation. If real GDP growth is higher than inflation, our economy is generally in good health. If on the other hand inflation exceeds real GDP growth, we may be entering a state of slow growth, high unemployment and high inflation. Stagflation, for short.

This does not mean that we will get stagflation each time inflation exceeds real GDP growth. It takes high inflation to produce stagflation. Last time we saw stagflation, during the Carter presidency, inflation and unemployment hovered around ten percent for a couple of years. We are not seeing inflation anywhere near these numbers yet, but the macroeconomic mechanics that lead to stagflation do produce the aforementioned symptom - inflation exceeds real GDP growth – and that symptom can occur even at low inflation rates. That does not mean that each time the symptoms occur we get stagflation, but what we do know is that we won’t get stagflation without this symptom.

To illustrate the importance of this indicator, consider the following data for the period 1980-2000. It starts in the Carter stagflation years and ends with the Millennium recession:

  • In 1981 inflation was 9.6 percent and real GDP growth 2.5 percent, inflation being 3.8 times higher than growth;
  • In 1982 inflation was 6 percent and real GDP growth -1.9 percent;
  • For the six years 1983-1988 real growth averaged 4.4 percent while inflation was 3.4 percent – a sustained period of prosperity;
  • During three of the four Bush Sr. presidential years, inflation was up to three times higher than real growth; unlike the late ’70s, this imbalance between growth and inflation did not lead to stagflation;
  • The entire Clinton presidency saw real GDP growth that exceeded inflation; Clinton’s real growth record fell short of Reagan’s at 3.8 percent, but inflation was also lower (1.9 percent).

We are now back in a situation where inflation exceeds real growth: inflation-adjusted GDP is expanding at 2.1 percent, while inflation is pushing past 2.5 percent. The question we have to ask ourselves is: is this a symptom similar to the late ’70s, or is it the same situation as we saw during the early ’90s and Millennium recessions?

One reason why this could be a stagflation symptom is that we are in the fourth year of a recession. As I explained last week, our economy is showing clear signs of weakening again, and when that happens we should normally see inflation taper off. Instead, every indicator points to sustained or even accelerating inflation. To see this, let us look at the latest reports on regional inflation from the Bureau of Labor Statistics. We start in the New York City metropolitan area:

For the year ended in March 2012, the CPI-U rose 2.6 percent, reflecting higher prices for shelter, food, and gasoline. The index for all items less food and energy increased 2.5 percent. For both indexes, the 12-month percent increase has changed relatively little since December.

Next stop Chicago:

Over the last 12 months, the Chicago area all items CPI-U increased 2.1 percent. The energy index rose 4.6 percent since last March, primarily due to price increases in gasoline. The all items less food and energy index was 1.7 percent higher over the year.

Then Boston, which seems to be doing a bit better than other large metropolitan areas:

Over the last 12 months the CPI-U was up 1.8 percent, largely due to higher prices for shelter, food, and gasoline. The all items less food and energy index rose 1.4 percent over the year.

Things are a bit different in Los Angeles:

Over the last 12 months, the CPI-U advanced 2.0 percent, the sixth consecutive month in which the  CPI-U rose by 3.0 percent or less. (See chart 1.) Energy prices increased 6.2 percent, largely the result of an increase in the price of gasoline. The index for all items less food and energy advanced 1.4 percent since March 2011.

There is a tendency among economists and commentators to dismiss high inflation when it is concentrated to “food and energy”. But that is a big mistake. The stagflation crisis during the Carter presidency was, essentially, an energy price crisis, yet it was capable of bringing the U.S. economy to a grinding halt. The rapid rise in energy costs spilled over into several other sectors and made life miserable for Middle Class America.

That can easily happen again, especially if inflation keeps rising and GDP growth keeps slowing down.

Again: so far we have only seen the very first symptom of stagflation. Hopefully we can dodge this bullet. But the longer we go on without an economic policy that aims to restore prosperity and economic freedom in our country, the harder it will become to avoid – or evade – stagflation.