New York Times Death Spiral Watch
Nixonland Is Here!

Stagflation Watch

Tim Duy is grim, over at Mark Thoma's Economist's View:

Economist's View: Fed Watch: Inching Closer to the Reality of Stagflation: It is increasingly obvious that the Fed is in a no-win situation. The best case scenario for the Fed is that nominal wage growth is kept in check by a deteriorating labor market. This will help contain inflation expectations and prevent a more serious 1970s type of environment. But overall, Jim Hamilton is correct; they are unable to both contain inflation and prevent a significant economic downturn:

In any case, the tightrope analogy seems a misleading way to frame the issue, in that it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate, and the notion that we can address the difficulties with a sagely chosen combination of monetary and fiscal stimulus and regulatory workout is in my mind doing more harm than good. Better for everyone to admit up front just how bad the problem is, and acknowledge that there is no cheap way out.

The nuance I would add to Hamilton's position is... the additional problem of a fundamental imbalance between production and consumption in the US.... Global financial markets... increasingly find it difficult to sustain this imbalance. Brad Delong hit the nail on the head in 2004:

That's the thing about accounting identities like S - D - I = NX. Either you craft economic policies that make them hold at full employment, or the market takes care of making sure that they hold for you--but usually not at full employment. Stagnant or falling wages that boost corporate profits could boost savings S by boosting retained earnings. A Bush administration serious about cutting the deficit could provide financing for investment and keep interest rates from rising. Big booms abroad could raise U.S. exports and reduce investment as the Fed took steps to shrink investment to avoid inflationary overheating. Otherwise, it is indeed hard to argue with Barry just across the north wall of this office: the dollar falls; has the fall produced enough inflationary pressure to lead the Fed to raise interest rates and so reduce investment and the current account deficit? no? then repeat.

The Fed is currently in the "then repeat" stage, although driving down the Dollar appears to have accelerated the surge in commodity prices, while the near term impact on export growth will be hindered by the need for structural adjustment (if only we could export vacant houses). At this point, more policy thrown at impeding this adjustment will only yield more inflation....

The inflation, of course, serves a purpose -- it is a market response to excessive consumption. Policymakers who want to pretend that the fundamental economic problem is insufficient demand rather than excessive demand will find the market yields a solution -- higher inflation to depress consumption via declining real incomes and wealth. Not a pretty solution, but a solution. Perhaps we are well past any other solution.

Bottom Line: I stick with the 50bp call because it is the most rational of the Fed's likely options....

Update: Greg Ip at the Wall Street Journal also covers the stagflation story this morning. This passage, which I agree is an accurate assessment of Fed policy, is both enlightening and scary:

Core inflation rose and fell with energy inflation between early 2006 and mid-2007, and the Fed thinks the same thing is probably happening now. If energy and food prices stop rising -- they don't have to actually fall -- both overall and core inflation should recede.

So far, they're still rising: wheat, oil and gold hit nominal records last week. But Fed officials don't think the latest jump can be justified by fundamental supply and demand. U.S. inventories of crude oil and gasoline are plentiful. Strong demand from China isn't new and should have been factored into prices long ago. A more likely explanation: investors, perhaps alarmed by the Fed's dovish stance, are pouring money into commodity funds and foreign currencies as a hedge against inflation.

Such fears can be self-fulfilling as higher food, energy and import costs work their way into consumer prices. But speculative price gains can't be sustained if the fundamentals don't support them. If the Fed and the futures markets are right, prices will be lower, not higher, a year from now.

The learning curve on Constitution Ave. is remarkably convoluted. The Fed wasn't willing to describe either the tech or the housing markets as a bubble since it is not their job to define fundamental values, but apparently is eager to define the "fundamental" value of commodities, and quick to dismiss current valuations as a bubble.

What is clear is that the Fed remains eager to dismiss any inconvenient information. And, remarkably, a basic lesson that should have sunk in over the past decade is that even if you believe an asset bubble exists, it can continue for much longer than "fundamentals" would justify. Moreover, this piece reads as if there is no fundamental reason for the Dollar to be falling; instead, we are witnessing a bubble in all other currencies. Yet if I pull any international finance book off my shelf, I am pretty sure I can find some reference that the "fundamental" value of a currency has something to do with interest rate differentials. Not to mention the yawning current account deficit.

I hope the Fed is correct, and I will be the first to admit error, but for now I am not willing to dismiss the signals commodity prices, or the Dollar, are sending.