Stagflation with a twist

Along with disco, leisure suits and Watergate, one of the horrors of the 1970s was stagflation. Economic signs in April hinted at its return, with a 21st century twist that could be especially hard on money market accounts.

Stagflation is a worst-of-both-worlds mix of a stagnant economy and high inflation. As of yet, it is still far too early to say that stagflation has taken hold. However, given the utter trendlessness of the economy since emerging from the Great Recession, it is important to be alert to signs of a new direction -- especially when that new direction could have distinctly negative consequences.

Chaos and economics

Economics is prone to conditions that call to mind chaos theory: Given time and a sequence of interacting elements, two seemingly similar situations can lead to very different outcomes. These differences sometimes defy the classical patterns and relationships of textbook economics.

For example, inflation is classically thought of as a side-effect of strong economic growth. After all, prices are sensitive to demand, so strong demand would tend to cause prices to rise more quickly. By the same logic, weak demand would tend to cause prices to sag, which is why deflation is often associated with a very weak economy, as was the case in the 1930s.

However, things sometimes get twisted around. The relative scarcity of some element of the economy -- such as labor, manufacturing capacity or a vital commodity -- can trigger inflation without the economy being especially strong. Higher prices when people are struggling financially means they can afford to buy less. Thus, under these circumstances, the economy stagnates in the presence of high inflation.

A stagflation flashback

In the 1970s, oil embargoes triggered shortages that spiked inflation upward. This created a further drag on an already weak economy, leading to stagflation. A couple of key economic reports in April summoned echoes of stagflation, and once again oil prices may play a central role.

In mid-April, the Bureau of Labor Statistics (BLS) released its inflation report for March. After being very docile in the fourth quarter of 2011, inflation has picked up so far in 2012, especially in February and March, and gasoline prices have lead the way.

This accelerating inflation comes at a time when growth may be fading. Earlier in the April, the BLS reported that job creation had slowed suddenly in March, with a net total of just 120,000 new jobs for the month.

Again, it's still too early for all this to be definitive, but slowing growth along with rising inflation led by gas prices could soon add up to an unpleasant 1970s stagflation flashback.

The 21st century twist

In the 1970s, an inflation-fighting Federal Reserve pushed short-term interest rates up, often into double digits. This helped deposit accounts keep up with inflation to some extent.

The 21st century twist is that the Fed's recent actions have focused solely on trying to stimulate growth. Thus, they have pushed short-term rates down near zero, which has affected money market rates. As long as growth remains sluggish, the Fed seems determined to keep rates low. This means that if stagflation takes hold, it could be especially damaging to money market accounts this time around.

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