You can’t have stagflation without the ‘flation

by pdxblake

A common criticism of the Federal Reserve is that the stimulus undertaken by the Fed keeping rates at 0% and doing quantitative easing (QE) twice followed by Operation Twist is that 1) it isn’t working, and 2) that it will either cause hyperinflation or stagflation in the future.  The accusation of ‘stagflation’ is often made with the blame largely focused on Obama (just do a Google search for ‘obama stagflation’) on the theory that the economy’s slow growth following a financial crash and bursting of the housing bubble is due to Obama not being austere enough (how’s that working out England?) or because he has not deregulated the industry that bears some of the responsibility for the financial crisis.

The Obama stagflation critics never get to the facts of 1) It was always going to be a slow recovery because that’s what happens after banking crises, 2) The Republicans have made it their mission to keep the economy dragging by opposing any federal policies that might improve it because they really, really want to beat Obama in 2012, 3) the stimulus wasn’t large enough for the size of the crisis.  Republicans also love to bring out the chart of the Administration’s projections for unemployment with and without the stimulus (to ‘prove’ that the stimulus failed):

Of course, what that really shows is that things got much worse than their projections and in reality, it was not that the stimulus was too small, the further deterioration before the stimulus had time to make an impact led to a “we need a bigger boat” moment, which the Republicans cynically capitalized on to deny any more help to the economy to help their electoral chances.  (And if you doubt that Republicans could be that cynical, then maybe you should click here).

The whole reason for bringing up stagflation is to remind people of the 1970s when people dressed like this (ht Slam Online) and to try to convince people that Obama is just like Jimmy Carter (“history’s greatest monster”) and that we have returned to the 1970s.  Which brings the post back to the Fed and inflation.  Stagflation requires two things: stagnant growth with persistent unemployment, and high and rising inflation.  There is slow growth in both GDP and employment (see above), but unemployment is slowly coming down and inflation right now is low.

There’s not much case from the chart above for 70s-like stagflation, since there’s no inflation, certainly nothing like the 1970s where inflation was not only high, but increasing across the decade until the Fed stepped in and raised interest rates, leading to 2 recessions in the early 1980s, but brought inflation under control.  Economist Tim Duy (ht Mark Thoma) suggests that the Fed may have given up trying to lower the unemployment rate because they have defined their unemployment target loosely while setting a strict limit of 2% for their inflation target.  As a part of Duy’s post he finds an excellent quote from Brad DeLong about the passivity of the Fed in the face of high unemployment and compares it to the passivity of the Fed during the 1970s, which I think is a much stronger connection than any idea of a return of ‘stagflation’:

In my view, there is an odd symmetry between the Federal Reserve of today and the Federal Reserve of the 1970s. The Federal Reserve of today does not take effective steps to reduce unemployment because it thinks any risk of sustained inflation above 2%/year is unacceptable. The Federal Reserve of the 1970s did not take effective steps to control inflation because it thought sustained unemployment above 7% was unacceptable. Since then, the Federal Reserve of the 1970s–Arthur Burns and G. William Miller–have been censured, condemned, scorned, and damned for their failure to understand the situation they were in and their proper objective function.

And as a result, the Fed today is going down the path of resting on their laurels from saving the financial system from total meltdown, but pushing down a path towards almost certain condemnation down the road for passively abiding while the unemployment rate sat at high levels because of their own belief in a 2% inflation target and their willingness to succumb to political pressure from a party that has made a Ayn Rand message about monetary policy its guiding vision.