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Friday, January 18, 2008

Inflation and Recession III - Podcast Transcript

As we said in October, it’s not inflation OR recession, it’s inflation AND recession. Since then, Joseph Stiglitz has confirmed “Stagflation Cometh.” See his commentary on Project Syndicate.

Every once in a while I listen past the adds on APM’s Marketplace.

Put it together, high inflation and a slowing economy, and it could equal stagflation. Marketplace’s Jill Barchet looks into whether that scourge of the Seventies might be coming back.


When the economy wobbles, it’s usually inflation OR recession that’s doing the shaking. Inflation usually hits when the economy is booming. High demand for goods pushes prices up. When recession bites, the opposite happens. Demand drops and companies lower prices to move product out the door.

But when high prices and a recession coincide, that’s stagflation. Central bankers haven’t got much in the way of weaponry. They can adjust interest rates or pump money into the economy.
As my son would say, “This is wrong in so many ways.”

We do not have to go back to the 1970s to find recession and inflation occurring together. We can stop at every recession between now and then, with the possible exception of the 2001-03 recession. And you would have to pick on the Guns and Butter era of the 1960s to find a place where a booming economy caused inflation.

What is the Fed to do? Fight inflation or stimulate the economy? This is causing a lot of angst on the FOMC, and elsewhere. At least consider the possibility that it can do neither. Monetary policy is exhausted by decades of liquidity.

Higher rates counter demand-pull inflations, overheating economies. The inflations we have experienced since the 1960s and Johnson’s Great Society and Vietnam War have been cost-push, often driven by higher energy prices. The one we have now adds the falling dollar. Higher interest rates will just add to costs, both for business and consumers. This effect offsets the reduction in demand, particularly since demand for services and goods is already contracting due to higher energy and higher food prices.

And lower rates will not stimulate the economy. The contraction of lending due to loss of capital — the credit crunch — will overwhelm any rescue except the “fiscal option.” Further, consider this, and we’ll spend an entire — if ten minutes can be an entire anything — podcast on this.... Anyway, consider this, that liquidity will find the rising asset prices. This comes from banking expert Charles Peabody whom I heard on one of those excellent NABE conference calls.

Parethetically, it also gives me the reason I may be wrong on the stock market. And a tip of the hat may be due to Nouriel Roubini and his “suckers’ rally” explanation. We’ll take that on with the next Forecast Friday, providing stocks don’t recover.

In Peabody’s view, the liquidity from action by the Fed is not mitigating housing, but is migrating to commodities – see gold and oil — and to currencies. Bidding up the prices of these is leading inflation higher, though now we have left Peabody’s thesis.

So it is not the Monetarist mechanism of more dollars chasing the same number of goods. It is instead an exacerbation of the costs of cost-push.

But the point of fallacy, the basic point of fallacy, in the current situation is that inflation and recession are somehow two sides of the same teeter totter. Further, the argument goes, since the Fed has only one tool — the interest rate — the Fed is in a pickle. This is the common perception. And it is not so.

The inability to distinguish cost-push from demand-pull means the Fed will apply high interest rates as soon as it can to stem inflation. The inadequacy of cheap money to do more than fuel higher costs means the lower interest rates have no economic purpose.

The Marketplace reporters should be forgiven, of course, for the myth of stagflation being confined to the 1970s and the rest. It is part of unchallenged economic lore.