Are We Headed for Stagflation?

The economic news for the 4th quarter of 2007 is in and it is not good. That’s an understatement of massive proportions, by the way. It's actually dire and in ways that we haven't seen since the intractable combination of recession and inflation, known as stagflation in the 1970s. I'll get to that in a minute. First the current numbers for the 4th quarter and what they mean.

According to reports from newspapers around the country, including the Chicago Tribune, the New York Times and the Washington Post, the unemployment rate surged from 4.7 percent to 5 percent. Economists, even at their most pessimistic, had predicted unemployment would only go up to 4.8 percent. This is the highest unemployment rate we’ve had since the recession of 2001 and the aftermath of the 9/11 attacks, or the immediate aftermath of Hurricane Katrina in 2005.

Only 18,000 new jobs were created. Economists had expected that at least 70,000 new jobs would be added to the economy. And that would have been below what’s needed to keep up with population growth. The economy needs to add 100,000 new jobs a year to keep pace with the population.

Some of the slowdown occurred in the housing sector, as was expected. According to the Washington Post, residential construction lost 28,500 jobs and 7,000 additional jobs were lost in the mortgage industry. As the Washington Post reported:

"We are on the verge of recession now," said Robert A. Dye, senior economist at PNC Financial Services Group. "We are teetering on the edge of a precipice, and it will not take much to push us over."

Economists have been hoping that the fallout from the downturn in housing and related crisis in financial markets would be contained to industries closely related to those businesses. That hope, it would appear, is not being borne out.

Indeed, problems in the housing industry, caused by the subprime crisis, are spilling over to other important sectors. Manufacturing contracted by 3,000 jobs for the quarter. For the entire year of 2007, 212,000 jobs were lost, 74,000 of them in the sagging auto industry.

What is more troubling, though, is that retail lost 24,300 jobs in December. The holiday season is traditionally a time when more jobs are added to the economy, albeit many of them are temporary. That usually skews the 4th quarter report and makes it appear stronger until it is seasonally adjusted. So that actually makes job losses in retail in December even worse news.

All of this would seem to call for an economic stimulus package. Already unions and politicians across the spectrum are agreeing on the need for that. But there’s an even greater problem here. Major newspapers across the country yesterday reported that we may be facing a threat of inflation, which could hamper attempts to stimulate the economy. Here are some quotes:

From the NYT:

“This is unambiguously negative,” said Mark Zandi, chief economist at Moody’s Economy.com. “The economy is on the edge of recession, if we’re not already engulfed in one.

The Fed has already eased rates three times since September in a bid to inject confidence into jittery markets. But analysts cautioned that central bankers may now feel constrained against further easing: inflation is growing, particularly as oil hovers near $100 a barrel. Lower interest rates, over time, can generate the seeds of inflation, and could make an already weak dollar worth less against foreign currencies.

“The Fed is trying to juggle a two-sided sword,” said Ryan Larson, senior equity trader at Voyageur Asset Management. “They’re trying to fight inflation moving higher and they’re trying to fight a slowdown in growth.”

From the Washington Post:

The Fed is in a tricky spot as it decides how much to lower rates. Oil prices touched $100 a barrel Wednesday and Thursday, and have risen in recent weeks with prices of other commodities. Lower interest rates would only exacerbate the threat of higher prices.

"The Fed is in the unenviable position of trying to serve two radically different taskmasters," said Bruce McCain, head of investment strategy at Key Private Bank. Fed Chairman Ben S. Bernanke "can't afford to let market psychology and economic psychology of consumers spin out of control. But we are seeing signs of greater inflation."

And finally, the Chicago Tribune:

The latest figures make it more likely that the Federal Reserve will move to lower interest rates late this month. But the inflationary pressures caused by sky-high oil prices could complicate the Fed's efforts to stimulate the economy with lower rates.

Sorry to be repetitive, but the point needs to be made that across the board economists and business writers fear a resurgent threat of inflation. Which means that we could be headed for something not seen since the late 1970s. Stagflation could be rearing its ugly head again.

The danger in this is that the classic tool for fighting recession is to stimulate the economy by cutting interest rates and pumping more money into the economy. And the classic tool for damping down inflation is to induce some mild recessionary pressure by tightening credit and getting some money out of the economy. Stagflation, however, is particularly nasty and intractable because neither of those alternatives is desirable. As its name suggests, it’s a form of economic paralysis.

The economy could be in dire trouble and so could the Republican Party heading into the 2008 elections. Then again, so could anybody who wins that election and gets stuck having to fix this mess.