Stagflation? That’s Not Econ 101

This week’s Courier Herald column:

When someone tries to use economics to justify what they’re proposing, they’ll often explain it as if basic economic principles demand it.  “This is just Econ 101.”

The problem with using entry level economics courses to try to explain real word reactions relies on some of the non-real world assumptions that are made to teach core principles.  Chief among them is the doctrine of “ceteris paribus” – meaning all other things other than the variable you are changing to show cause and effect remain the same.

Right now, we’re living in a very un ceteris paribus world.  We have supply shocks coming from oil and food disruptions due to a land war in Europe.  We have another demand shock coming from China as it once again tries to restart much of its economy after months of additional lockdowns.  The Federal Reserve is trying to withdraw $4 trillion in liquidity it created from the money supply while also raising rates.  Supply chains remain written on Etch A Sketches.

There are many forces working at cross purposes, which makes the job of policy makers even more difficult than usual.  The likely short term result as we work for long term stability is stagflation, at least in the near future.

Stagflation is the unambiguously undesirable combination of high inflation and no economic growth.  Normally, inflation is considered a result of growth that is “too hot”, with demand increasing faster than the supply of goods.  The preferred policy measures are to raise interest rates and reduce the money supply to rein in spending and thus prices.

When the economy is growing too slowly or begins to decline into recession, the Fed eases up and creates a more accommodative policy set with respect to interest rates and increases the money supply.  This has been the Fed’s posture for most of the last couple of decades.

We now have echoes of the late 1970’s, when prices were rising at ever faster rates, and the economy is showing some signs of cooling.  Right now, most of those signs are in the asset markets – specifically stocks, bonds, and the emerging cryptocurrency market.  Values are down sharply in these assets, with signs that the housing market may also be cooling a bit due to higher mortgage rates.

The Federal Reserve is trying to engineer a “soft landing”, whereby they are able to return these markets to more normal supply vs demand balance without destroying underlying growth.

To kill off the surging inflation a generation ago, Fed Chairman Paul Volker raised short term interest rates to 20% in 1981.  Mortgage rates hit 18%.  It worked, and the economy cooled.  In fact, it got pretty cold.  Unemployment a year later crossed 10% nationally.

Which brings us back to today and current Fed policy.  After losing the battle to declare inflation “transitory”, meaning the market would correct itself as pandemic induced supply shocks dissipate, they’re now aggressively increasing rates and reducing the money supply. 

The problem comes as consumers and producers alike reset their expectations.  Another core tenant of Econ 101 is that everyone has “rational expectations”, meaning they act based on what they perceive best for them given the information that is available.

Producers and retailers have been acting rationally in response to labor shortages and unprecedented demand.  They’ve been hiring everyone that is available, then producing and selling everything they could to meet insatiable demand.

Consumers, however, are starting to hit the brakes.  Target, Walmart, and Amazon all disappointed Wall Street expectations this quarter indicating that demand was normalizing, with the first two also stuck with a lot of unwanted inventory.   Just weeks later, Target has already reduced guidance again, saying they’re going to have to take losses on a lot of inventory in categories no longer desirable to current market tastes.  Orders for some new inventory have been cancelled.

As consumers pull back, companies quit hiring.  Layoffs are increasing at high-growth but unprofitable tech companies that flourished under easy money and investment conditions.  So while the Fed is fighting inflation, producers and consumers alike, acting rationally for what they are experiencing, are tightening their belts.

It’s likely to get messy from here.  If the Fed moves too quickly, record low unemployment can quickly become an employment problem.  If they ease up too quickly, more of America’s purchasing power can erode with the tax of inflation.

Economics has never billed itself as an exact science, just a dismal one.  Current conditions are challenging even the most accomplished experts.  We’re well beyond the entry level 101 level as we continue to try to restart the world’s economy.  Buckle up, it’s likely to be a bumpy landing.