Don't Look Now, But Stagflation May Be Here

Stubbornly high unemployment has been the bane of this economic recovery. Inflation has been creeping higher for months. And on Wednesday, data tied to a key manufacturing index was disappointing, to say the least.

All of this turmoil has kicked up the volume on warnings that the U.S. is headed into a period of stagflation, a dreaded economic condition marked by sharply rising consumer prices accompanied by miniscule growth.

Consider what that would mean to the average consumer who has to pay more for everything from a gallon of milk to a new car, but cant expect a raise any time soon because his company is just getting by.

And that's assuming that the consumer has a job at all.

To me the definition of stagflation is rising prices while theres a soft labor market. If those conditions were mutually exclusive we wouldnt have the word stagflation, said Larry Elkin, president of Palisades Hudson Financial Group, a financial planning and investment management firm in Scarsdale, N.Y.

Here are the numbers, just from today,  that have reignited talk of stagflation: the Consumer Price Index, a widely watched inflationary gauge, rose 0.2% on a month-over-month basis. Economists had predicted the index would rise 0.1%. Minus food and energy prices, which are viewed as more volatile than the costs of other consumer goods, the index was up 0.3% compared with expectations of 0.2%. And year over year, overall inflation jumped 3.6%, while core inflation (minus food and energy) was up 1.5%. Economists had predicted 3.4% for overall inflation and 1.4% for core inflation.

So inflation numbers came in higher-than-expected across-the-board.

At the same time, the Empire State manufacturing index for June was an eye-opener. The index came in at -7.8 versus expectations of 12.

On top of it all, throw in unemployment, which jumped back over 9% in May.

This is what a mild case of stagflation looks like, and it doesnt look very good, Elkin said.

The last time the U.S. faced an extended period of stagflation was in the 1970s, and fiscal policy makers pulled the country out of it by raising interest rates to curb inflation at the expense of a painfully high unemployment rate.

Elkin said a similar remedy is needed today. There is no painless answer, he said.

The Federal Reserves so-called loose fiscal policy in the wake of the recent financial crisis has included printing trillions of dollars of U.S. currency and keeping interest rates at a range of zero to 0.25% for over two and a half years.

Elkin is one of many who believe these policies have contributed to rising global inflation and that its time for the Fed to tighten its policies.

Although many forces buffet the U.S. economy, the near-zero interest rate policy of the Federal Reserve is the prime contributor to the current bout with stagflation, Stanford economist Ronald McKinnon wrote in The Wall Street Journal recently.

The Fed has defended its policies, arguing that inflationary pressures, in particular rising commodity prices, appear to be temporary, or transitory, in Fed parlance.

For months Federal Reserve Chairman Ben Bernanke has made the case that oil prices rose earlier this year as a result of political unrest in the Middle East, and that natural disasters around the world have impacted both the price of food and various other consumer goods as the earthquake in Japan disrupted manufacturing and supply chains.

While oil prices have leveled off in recent weeks and even fallen in some areas as turmoil in the Middle East has cooled off, food prices have continued to rise.

Elkins heard enough of the "transitory" explanation. What does Japan have to do with the price of corn, he asked rhetorically.

Hold on, though, the sky isnt falling, said Marc Pado, U.S. market strategist at Cantor Fitzgerald.

I dont think that a one-off event should be extrapolated into a whole trend, Pado said.

If inflation combines with a stagnant economy for two entire quarters, Pado said hes ready to consider stagflation. But thats hardly been the case.

Whether you agree with the Feds policies or not, the fact remains that extreme weather has impacted global commodity prices, and that political unrest caused the price of oil to jump during the spring, Pado noted.

Whats more, Pado said the Empire State manufacturing index isnt as widely watched as other regional manufacturing indexes because New York hasnt been a hotbed for manufacturing for a long time.

You have to look at these numbers in context, Pado said. There were clearly well-defined disruptions in the system that are working their way through.

He added, You can focus on right now but you dont typically get stagflation without excess inventory and over-employment. Its the excesses in the system that cause slowdowns and we dont have excesses. Its going through a rough patch, but by most accounts its transitory.