5 Principles of Stagflation

Fed Chair Jerome Powell speaks at the Brookings Institution in Washington, D.C., on Nov. 30, 2022. Drew Angerer/Getty Images

Commentary

Stagflation is the combination of slow or falling economic output plus high inflation. For nearly two years, we’ve been stuck in this pattern and it still feels confusing. Prices for many items such as cars and homes have whipsawed around in strange ways, up one month and down the next, only to repeat the pattern.

As inflation started, many people believed the official line that this was “transitory,” a word that people heard as “temporary.” If you think about it, the word transitory is meaningless as a predictive tool. It means moving from one thing to another thing without saying what the thing is. It turns out that transitory meant a transition to a permanently and dramatically weaker dollar from 2019 prices.

People such as Treasury Secretary Janet Yellen likely knew this. They just wanted to calm people’s fears and keep them believing false things until the midterm elections. Contrast that to how this crowd handled the virus of 2020: They promoted public panic in every possible way as a means of terrifying the population into compliance and ultimately turning against the president. Indeed, that was the goal all along.

In any case, it should be obvious by now that inflation is the new normal. We’ll never see 2019 prices across the board again, simply because for that to happen, the Federal Reserve would have to tolerate a deflation of 12 to 15 percent. If that does happen—and it’s highly unlikely—it won’t be because the Fed wants it that way. It would suggest that the Fed had lost control completely.

Consider five principles of stagflation.

No. 1: There are no hydraulics. For decades, from the 1930s to the 1970s, economists and others who thought about this topic believed that the planners in Washington had access to some master control board that allowed them to carefully manage big economic forces. They were based on what came to be called hydraulics, large aggregates that could be pushed and pulled like a mechanized machine.

These large forces went by easy names; unemployment, output, capital, consumption, and inflation. The theory was that our D.C. masters could force unemployment down by forcing inflation up. It could boost output by increasing government spending, and could dig us out of recession by reducing taxes with resulting debt that would be paid later. The plan included some fancy trickery, too, such as the “wage illusion”—making workers believe they were getting raises when, actually, their purchasing power was falling.

A central doctrine of this way of thinking was that inflation and unemployment couldn’t rise together over the long term. That’s another way of saying that stagflation was impossible. Then, of course, in the 1970s, it became normal, thus blowing up the whole theory. That was embarrassing and started a scramble for a new theory of macroeconomic management that we still don’t have.

No. 2: There is no price level. Too often, economics deploys metaphors that are really statistical artifacts, and so it is with the phrase “price level,” which makes us believe that prices rise and fall like the sea level. In fact, the level as we know it is nothing but a weighted average of prices as we can find them, including some but excluding others. That’s why the stock market—which chronicles the price of financial assets—isn’t included.

An index number necessarily obscures underlying realities, so, for example, during the great period of more-or-less stable prices from 1985 to 2020, we saw a huge deflation in the price of computers, software, and clothing. That helped mask the large increases in other areas of economic life, resulting in an average that wasn’t alarming. Note that the deflation in these sectors wasn’t inconsistent with rising output and profitability, thus giving lie to the claim that falling prices are something always and everywhere to dread.

No. 3: Labor markets are affected, too. It was also a doctrine for nearly a century that recession/depression was marked by high unemployment. But that figure, too, is subject to all kinds of exigencies of data collection and calculation. When the Labor Department last week announced vast job creation, people yelled huzzah, without noticing that labor force participation and the worker/population ratio both fell again! The press release stated that both figures were “little changed,” but I’ve learned what this means: they fell. Both are still below pre-lockdown levels. That’s to say, these markets aren’t healthy. Job creation here means that existing workers are taking second and third jobs.

Labor, like capital, isn’t homogeneous. We’re seeing a tremendous culling take place in the professional class of workers who lived the life of Riley during the lockdowns. They swam in a bloated lake of workers in Big Tech and media and there never seemed to be a shortage of funding simply because the Fed was keeping real interest rates at less than zero. This set off a scramble for return that eschewed the safety of short-term bonds in favor of long-term speculation.

We may eventually see unemployment numbers tick up, but the reality is that we could be sinking into deeply depressed output without that number ever again rising above 5 or 6 percent.

No. 4: A sector can be depressed with rising prices. We encountered this paradox earlier this year when housing prices were still rising even as demand was falling. That’s because the Fed had already started its campaign for tighter money but sellers were still able to command high prices. That has started to reverse as demographics have stabilized and now many regions of the country have a surplus of housing for sale that no one wants. Prices will continue to fall as the 30-year mortgage rate rises, all in the interest of seeking some equilibrium.

No. 5: Overall prices likely won’t go back. The Fed has no choice but to continue its rate increases, but inflation is already embedded with a very long way to go. We can look for 6 percent overall increases for two years at least, meaning that all the pain you’ve already experienced will go nowhere and only get worse. The Fed’s objective here has to be to get rates into positive territory.

As David Stockman writes: “The real skunk in the woodpile is that debt yields are still hideously under-priced. Period. Accordingly, the Fed will have no choice except to keep raising nominal rates until real (i.e., inflation-adjusted) yields get back into meaningfully positive territory. And that means there’s still a long ways to go. That is to say, the real yield on the benchmark 10-year UST touched a low of -6.4 percent in March 2022, but after 400 basis points of Fed funds increase, the real yield is still -3.8 percent (October). ... That means nominal UST yields need to reach the vicinity of 7-8 percent in order to eliminate the deep subsidy for debt built into the yield curve at present.”

Only this path will “get the financial signaling system back on a productive, sustainable path, thereby removing the massive bias toward excessive debt accumulation and the bloated inflationary demand which it finances.”

All the features of stagflation are going to be with us for the duration, with falling output, rising inflation, and increasing tightness in the higher-end sectors of the labor market. It wasn’t supposed to be this way. We were told that between monetary and fiscal policy, the wise planners in Washington had all things under control, just as they did with the virus. We look around us today and observe nothing but failure. ... or treason.