MEDIA CONTACT: Dr. Mike Walden, 919.515.4671 or michael_walden@ncsu.edu

YOU DECIDE: Will 'stagflation' return?

By Dr. Mike Walden
North Carolina Cooperative Extension Service

Some economists are now uttering the “s” word: stagflation. Inflation and deflation we might understand, but what kind of economic mumbo-jumbo does stagflation imply, and why should we care?

Stagflation is constructed from parts of two other words. “Stag” is short for stagnation and refers to a sluggish economy with job shortages and little income growth. “Flation” stands for inflation and signifies rapidly rising prices.

Combining the two parts and their meanings, we come up with stagflation, which indicates an economy running on empty in terms of jobs and income, but in which prices are rising fast. So stagflation is not a happy time for the economy, and especially not for households.

Stagflation came into our vocabulary in the 1970s to describe the economy of that decade, which was in a recession-like state, with unemployment high and income growth low. Yet at the same time, inflation, led by rising oil and gas prices, was high.

In fact, a special measure was developed to describe the misery created by stagflation, the “misery index,” the sum of the unemployment rate and the inflation rate. With both rates near 10 percent, during some of the '70s, the misery index stood at a lofty level of 20.

What was so unusual about stagflation was that it wasn't supposed to happen. Prior to the 1970s, economists observed – and therefore believed – that when unemployment was high, inflation was low, and when unemployment was low, inflation was high.

The idea was that when unemployment was high, a lot of slack, or unused capacity, existed in the economy that would stifle price increases. Conversely, when unemployment was low, there was little unused capacity in the economy, and any attempts to expand production would push up prices.

The stagflation of the '70s destroyed these relationships, and some economists see a possible repeat today: an upcoming major economic slowdown caused by a sputtering housing market, consumers overextended with debt and businesses hampered by foreign competitors. At the same time, energy and raw material price jumps are pushing up inflation indicators.

Is stagflation today a sure bet?

Not necessarily, say other economists. While the '70s brought the unpleasant combination of high unemployment and high inflation, many of the years of the '80s and '90s brought the opposite: low unemployment and low inflation. Today's misery index is at a relatively low value of 7.

The Federal Reserve seems to hold the key to preventing stagflation. Hindsight now reveals the mistake made in the 1970s that led to stagflation. When energy prices rose, the Fed effectively printed more money to try to “fool” the economy into thinking those high prices could be afforded. Eventually, however, this extra cash caused across-the-board price increases.

The ball is therefore in the hands of the Fed, which has the power to head off stagflation, particularly the inflation component. While the Fed can't prevent higher oil or copper prices, or, for that matter, higher prices for any individual commodity, through proper control of the money supply, it can contain these price increases to individual markets.

With the uncertainty about the future course of the economy so high, all eyes are trained on Fed Chairman Dr. Ben Bernanke and his colleagues. While they can't necessarily give us the best of all economic worlds, they can prevent the worst of all economic worlds: stagflation.

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Dr. Mike Walden is a William Neal Reynolds Professor and extension
economist in the Department of Agricultural and Resource Economics of North
Carolina State University's College of Agriculture and Life Sciences. He
teaches and writes on personal finance, economic outlook and public policy.
His You Decide column is provided every two weeks by the Department of
Communication Services. Earlier You Decide columns are available on the Web
at http://www.cals.ncsu.edu/agcomm/writing/walden/decide.htm
Related audio files are at
http://www.ces.ncsu.edu/depts/agcomm/writing/walden/index.html