On the Arrival of 70's Stagflation: It's like deja-vu, all over again!

The US Labor Department data on February 19th, showed core Consumer Price Index, which excludes the more volatile food and energy components, increased 0.3 percent in January, the biggest gain since August 2011. The annual core CPI advanced 2.2 percent, compared to the market expectations of 2.1 per cent, the largest rise since June 2012 and exceeded the 1.9 percent average annualized increase over the last 10 years.

This trend would get the Federal Reserve closer to its 2 percent target on the PCE inflation and together with a tightening labor market, provides some impetus for additional rate hikes. According to the minutes of Federal Reserve's January 26-27 policy meeting, policymakers still expected to raise rates and even discussed whether a hike was warranted in that month, but after a lengthy discussion on global risks they said tighter financial conditions may be "roughly equivalent" to further hikes!

It appears, that the U.S. economy is headed for stagflation. Clearly, Fed’s signals with regard to a need for early and modest action toward "normalizing" policy with the ultimate goal of staying ahead of the inflation curve is proving unhelpful and is adding to the current extraordinary uncertainty.  In brief, as we have argued before in this forum, businesses’ capacity planning horizon has shortened in recent times and this is one of the key contributing  causes of the emerging stagflation .

Firms' survival strategy is now determined by their optimization along their short-term cost functions, and this is evident from the lack of investment in capital formation. The reluctance to commit capital to irreversible fixed investment and waiting for uncertainty to abate, stemming from the prevailing global imbalances and their impacts on credits that are rooted in extraordinary amount of global debt overhangs, rising non-performing loans, slowdown in China, and oil price shocks are causing a decline in the potential GDP growth.

Firms caught in these circumstances have resorted  to contingency capital and labour planning to meet any conjectural increases in demand, and this is corroborated by a rise in part-time work and the stagnating wages. These effects are artificially reducing the official unemployment rate. It should be noted that these effects are exacerbating the Not-in-Labor-Force population problem, which based on BLS estimate is 12-times the number of “officially unemployed”, and is  expected to steadily rise.

The use of contingent workforce is increasingly widespread and rising particularly during these uncertain times. Firms use this short-term optimization tactic because it will provide extra flexibility and cut labour costs sharply, by eliminating the need to pay contractual fixed wages, benefits, sick days and vacation days, or overtime. Moreover, it isn’t necessary to withhold taxes, pension plan contributions, or employment insurance premiums and so on, and  payroll, benefits administration, and HR costs are also reduced.

 Although to our  knowledge, the literature on job search has not yet investigated the impact of a greater use of contingent workforce on regular-jobs’ search costs, it stands to reason  to expect that these costs must have risen markedly for the unemployed in particular. This is why many unemployed workers are deciding to provide their services through a temporary agency, or work as intermittent workers, “casual” workers, and other types of works without a standard employer-employee relationship, which are all referred to in the U.S. as “contingent workers”, and are playing a significant role in the stagnation part of the stagflation.

As well, all the needed ingredients are in place to create the inflation part of the stagflation, and in this regard Fed’s policies have become inconsequential from a stabilization policy perspective. Since a hypothetical rise in interest rate would intensify the stagnating part of the stagflation, and on the other hand a reducing interest rate would add to its inflationary part and simultaneously  would aggravate the prevailing macroeconomics’ imbalances.

The underlying reasons for the fact that inflation had remained weak in recent quarters have been articulated quite well by the Fed’s recent release;

“Inflation is expected to remain low in the near term, in part because of the further declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further.” 

In other words, because of the mathematics of calculating the annual inflation rate, those parts of the inflation weakness arising from impacts of lower oil price and lower import prices stemming from the US dollar appreciation, which are transitory and normally should be expected to disappear after a year would linger for a while, because of the fact that oil price declines have been staggered and have not occurred all at the same time, and thus  their adverse impacts on annual inflation rate may be enduring for more than one year. Nonetheless, sooner or later, they will disappear.

However, there is no danger of creating memories in the data, arising from the persistence of inflation weakness. Meaning inflation expectations would remain anchored. Obviously then, the inflationary pressures would be reinforced by the above mentioned  lower rate of potential GDP growth rate that would reduce the impact of the notional output gap (measured against the theoretical longer-term cost functions) .

 This stagflation could be exacerbated by the appreciation of the US dollar real effective exchange rate, which has been showing a trend, owing to a kind of currency wars, and a relatively safer haven quality of the US vis-à-vis other countries that entice the  inflow of capital. The February 17th data on the producer price inflation registering a 0.1 percent increase appear to suggest that this process is already started.