Stagflation is a condition of high unemployment and high inflation. This creates a policy dilemma for the Federal Reserve because they can only effectively tackle one of these problems at a time. If the Fed raises interest rates to lower inflation, they will increase unemployment. If the Fed lowers interest rates to decrease unemployment, they will increase inflation. Either way, their policy actions in eliminating one problem will likely exacerbate the other problem. In short, it’s a terrible place for a central banker to be. The US last faced this problem in the late 1970s. To cure the problem, Paul Volcker increased interest rates to very high levels to lower inflation. This was a very painful process that caused a lot of pain for many people.
Currently, there are some underlying trends in the US economy that are hinting at the possibility of stagflation. I want to caution: these are the initial stages. Nothing is set in stone. However, over the last month the unified chorus of Federal Reserve members who have cautioned about inflation has jumped out of the headlines. This combined with poor job growth over the last 5 years leads to the conclusion the initial stages exist.
This diary is far longer than I normally write and prefer. However, I think the need to present as much information on this topic is more important than brevity. In addition, some of you have read part of the inflation information yesterday. Yesterday the number of Fed inflation hawks increased by 3 and a further report on price spikes in another economic sector came out. Once I put these Fed warnings, economic indicators and poor employment situation together, I grew very concerned.
Inflation
Atlanta President Jack Guynn on October 3:
“I consider inflation risks to be elevated at the moment, he said. “I think one has to give considerable weight to the fact that not only in some of the headline measures, but in some of these core measures, we may see the pass-through of at least some of the energy cost increases.”
Federal Reserve Bank of Kansas City President Thomas Hoenig on September 26:
Hoenig noted that the consumer price index has already pushed up significantly from a year ago, thanks to high energy prices, while unit labor costs were rising and economic capacity was being absorbed by the strong U.S. economy.
“When you see all three coming together you must be alert,” he said. “The mission of the Fed is to be sensitive to these pressures.
San Francisco Federal Reserve President Janet Yellen on September 27:
She said higher energy prices “put U.S. monetary policy on the horns of a dilemma” as policymakers balance possible passthrough of prices to core inflation against potential long-lasting cuts in consumer spending if high prices persist.
“Estimates of the extent of spending are escalating, and the recovery and bounce-back, fueled by massive fiscal stimulus, could propel the U.S. economy on an unsustainable upward trajectory,”
Chicago Feder Reserve President Michael Moskow on September 26:
Michael Moskow said there may still be excess capacity in the nation’s economy but that inflation is running at the upper end of the Fed’s comfort zone – a position he’s offered in other recent speeches.
Dallas Federal Reserve President Richard Fisher on October 4:
“Inflation has been on an upward tilt the past couple of years. Now, the inflation rate is near the upper end of the Fed’s tolerance zone, and shows little inclination to go in the other direction,” Fisher said in a speech Tuesday to the Dallas Chamber of Commerce.
Philadelphia Federal Reserve Bank president Anthony Santomero on October 4:
“To keep cyclical price pressures and any transitory spike in energy prices from permanently disrupting the price environment, the Fed will have to continue shifting monetary policy from its current somewhat accommodative stance to a more neutral one,”
St. Louis Federal Reserve President William Poole on October 4:
“I have no doubt that both the FOMC and the market would respond to surprises in core inflation that seemed likely to be persistent and to indicate a developing inflation problem,”
First, let me offer some explanations. The Fed’s policy is accommodative when they was the economy to expand. This means lowering interest rates to a low-enough point to stimulate borrowing. The Fed’s policy is neutral when they feel rate levels are low enough to stimulate economic growth through borrowing and high enough to prevent inflation from increasing. The Fed’s policy is restrictive when rates are high enough to prevent economic growth and inflation. There is no empirical formula to derive these levels. It is largely based on the personal perception of various members of the Federal Reserve.
So, what are they worried about? First there is the increased cost of energy. That is concern enough. However, there are indications at other levels of the economy that inflationary pressures are increasing. Each month, various Federal Reserve regions issue a regional manufacturing report that is broken down into various sub-categories. The price categories of these reports have all shown a recent sharp increase in prices. The Empire State Index’s recent prices component increased by 20 points. The most recent Richmond Federal Reserve Survey showed an increase in the projected prices paid for future manufacturing inputs. The most recent Philadelphia Manufacturing Survey also showed a sharp increase in prices paid by manufacturers.
Several non-Federal Reserve Manufacturing reports have also showed a similar increase in prices. The recent National Association of Purchasing Managers Index showed a 14 point increase in its most recent survey. The latest ISM Manufacturing survey showed a sharp uptick in prices as well. Finally, yesterday’s Service Sector report also showed a sharp uptick of prices.
Unemployment
According to the Bureau of Labor Services, the official unemployment rate is 4.9%. However, is this an accurate rate? Reports from the New York Federal Reserve, the Boston Federal Reserve and the Congressional Budget Office (links below) have analyzed the divergence between the low unemployment rate and the higher labor participation rate. The evidence presented indicates unemployment is in fact higher that the unemployment rate would indicate.
The Boston Fed Study offers the most comprehensive analysis of the overall situation. It uses the labor participation rate as the basis for analysis of the current employment situation. The Boston Fed issued this report in mid-July.
The Study breaks the workforce down into sex and age group categories – for example, men age 16-17, men age 18 – 19 and so on. In total they have 14 different groups. There are 7 for each sex. In addition, the study breaks down each sex into the following age groups: 16-17, 18-19, 20-24, 25-34, 35-44, 45-55 and 55+. It might help at this point to either go to the study at the link below or draw out columns of a sheet of paper.
The study looks at each group’s labor participation rate in March 2001 and compares it to each group’s participation rate from November 2004 – February 2005. March 2001 was the final month before the last recession began. The percentage from November 2004–February 2005 provides as example of how each group is doing in the current cycle.
Here are the basic results. men and women over 55+ are the only group that is participating at a higher participation rate in November 2004 – February 2005 compared to March 2001. All other age groups are participating at a lower rate, particularly women. This drop in participation is most pronounced in both sexes teenage and early 20s categories. The report states it thusly:
“What leaps out … is the below-average recovery of participation in the current business cycle to date. The depth of the shortfall is most pronounced among teens and for women of all ages.”
The other Federal Reserve reports come to similar conclusions albeit in different manners. The bottom line is unemployment is probably between 1-3% points higher than the “official” unemployment rate. Inflation adjusted wage growth for the past 5 years has been anemic at best, indicating these reports of higher labor market slack are more accurate in describing the overall labor market situation. If the unemployment rate is indeed higher than reported, the stagflation scenario may be farther along.
Conclusion
First, I want to caution again: these are early signs. This is not a foregone conclusion.
Regarding the inflation outlook, the near unison inflation pronouncements from the Federal Reserve over the last month is an important warning regarding current Federal Reserve concerns. Inflation is clearly number 1 on their list – and possible number 2 and 3 as well. Higher prices are starting to have a wide impact on manufacturers and service providers prices paid. It is only a matter of time before these economic intermediaries will start to pass these increases on to consumers.
Regarding the actual level of unemployment, the last 5 years of job growth have been at best anemic. The US has lost nearly 3.4 million high-paying information technology and manufacturing jobs. According to the establishment survey, the US economy created a little over 1.5 million jobs from January 2001 – August 2005. While the household survey comes in at 4.6 million over the same period, that number is still too low to absorb the average monthly 150,000 displaced workers from attrition, seeking a new job, entering the workforce etc… Joe Liscio noted in the August 15 Baron’s: “It looks like the U.S. economy is now dominated by housing, shopping, eating and drinking (with some help from very expensive health care). These don’t look like core productive sectors.” In other words, the jobs created don’t pay as well.
The recent unanimous inflation pronouncements from Federal Reserve presidents sunk into the markets yesterday as the market sold-off breaching key technical levels. Traders are nervous about the outlook, especially with 4th quarter earnings season coming up. This nervousness combined with the weak employment situation is a proverbial double-whammy of concern. And it should be. Again, while nothing is definite, the initial occurrence of these combined economic warning signs should concern policy-makers.
