EXPLAINER | Stagflation on the radar for the US economy, but no repeat of the 1970s

Recent economic projections from Federal Reserve officials had shades of “stagflation-lite” in the words of one economist, a sentiment increasingly echoed among other observers of the US economy and central bank wondering if the country's outperformance during the pandemic is about to slide.

So what is stagflation and why is it suddenly on everyone's mind?

Stagflation, or a period of high inflation and high joblessness, hit the US notably in the 1970s, which may have featured the worst US economic leadership since the Great Depression. Fed officials had their data and their framework wrong and elected officials flailed against inflation with price controls and what now seem quaint public relations efforts, most notoriously the Ford administration's “Whip Inflation Now (WIN)” button campaign.

As economists in recent weeks have begun marking down their estimates of economic growth and marking up estimates of inflation in the face of dramatic economic policy shifts under President Donald Trump, it has sparked debate about whether that could be unfolding again now.

In theory, a weak economy with rising unemployment undercuts inflation, so the two should not coexist. But as with oil price shocks in the 1970s that drove prices higher, the tariff shock anticipated from Trump's trade policies now has the world guessing.

The Trump administration says the tariffs are part of what they bill as a transition for the economy that, coupled with other efforts to deregulate industry and cut taxes, will produce plentiful jobs and lower inflation.

The hints of stagflation in forecasts aren't nearly as bad as the 1970s, a decade in a league of its own when a surge in the so-called “misery index” combining the unemployment and inflation rates still stands out in charts of the postwar economy.

But the direction of travel for major aspects of the economy has caught economists' attention. When Fed officials this week assessed the risks they see ahead they pointed uniformly towards higher inflation and higher unemployment than previously expected.

“Stagflation-lite” is what RSM chief economist Joe Brusuelas titled his analysis of the Fed's meeting last week. Policymakers' forecasts “implied mild stagflation ahead in the near-term as growth slows and inflation increases”, he said, noting the “pervasive uncertainty around the size and magnitude of the trade shock”.

Fed policymakers last week left interest rates unchanged but still anticipate two quarter-point cuts by year-end. Their new economic projections, however, laid bare their conundrum. Growth is anticipated to slow, unemployment to rise a bit more than expected and inflation to accelerate in the face of existing and widening tariffs. Implied by their forecasts of rate cuts and higher inflation is a belief that tariff-triggered price increases would be one-off jumps, the same assumption the Fed made early in the pandemic when it called rising prices “transitory” — and was proved wrong.

Things are different now. Factories and ports are open and goods are flowing.

But given the scope and breadth of what Trump is planning, officials say the outcome remains unpredictable.

Hard macroeconomic data, as Fed chair Jerome Powell noted in his press conference last week, remain solid. The misery index is rather low. But softer measures such as sentiment are sliding, something policymakers feel could cause businesses to stall investment and hiring and households to cut back, even as tariffs lead prices to keep rising. Fed officials note growing concern among business contacts and have begun discussing the difficult choice moments of stagflation pose for a central bank tasked with controlling inflation while sustaining employment.

“There is nothing more uncomfortable than the stagflationary environment, where both sides of the mandate start going wrong. There is no generic answer. Which is worse? Is it bigger on the inflation side? Is it bigger on the job market side?” Chicago Fed president Austan Goolsbee said on Friday on CNBC. “Higher tariffs raise prices and reduce output so that is a stagflationary impulse.”

If the Fed is caught in the middle, their priority is clear: To ensure not just inflation but public expectations about inflation remain under control.

Perhaps the key mistake of the 1970s was a failure to understand better the role that public psychology plays in future inflation. Scarred by rising prices, Americans' belief that costs would keep on rising kept pushing prices higher even as the economy weakened.

It took punishing interest rates and two successive recessions under Fed chief Paul Volcker to begin to establish the Fed's credibility and reset expectations through the rest of the 1980s and into the 1990s.

That's a lesson Powell has said he takes to heart and one he says he won't repeat.

“I don't see any reason to think we're looking at a replay of the 1970s or anything like that. Underlying inflation is still running in the twos, with probably a little bit of a pickup associated with tariffs,” Powell said at a press conference after the Fed's most recent meeting. “I wouldn't say we're in a situation that's remotely comparable to that.

But stable inflation expectations are “at the heart of our framework”, he said. “We will be watching all of it carefully. We do not take anything for granted.”

​Reuters