Are You Ready for 'Stagflation-Lite'?

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And that was the big problem for the Fed. Monetary policy was too expansive for an economy with deteriorating productive capacity, calculates Athanasios Orphanides, an economist at the Federal Reserve who has delved into central bank policy during that troublesome era. (The research paper is "Activist Stabilization Policy and Inflation: The Taylor Rule in the 1970s," February, 2000.)

America's productivity growth rate is similarly suspect today. Productivity growth has averaged a healthy 2.6% over the past decade. Yet since midyear 2004, it has come in at a much lower, 1.6% pace. Some economists expect productivity will take another haircut as consumers' borrowing zeal of recent years cools off (BusinessWeek, 1/23/08). Still, it could be a long time before the trend in productivity is clear, raising the risk that the Fed overestimates the economy's speed limit and, like the 1970s, ends up with a too-loose monetary policy that results in higher rates of inflation.

Investors Hedge Against Inflation

It's striking how investors are snapping up assets that boomed during the inflationary '70s, pushing them to high levels—and even record prices. For instance, while the dollar is trading at low levels in the international currency markets, gold, a classic hedge against inflation, is near its record price, now at $919 an ounce. Prices for key commodities such as oil, food, and platinum, are at nosebleed levels. The stocks of companies in industries with a history of "pricing power" such as cereal makers and electric utilities are attracting investor interest. Indeed, almost all the traditional safe havens against the ravages of spiraling inflation are doing well. And the last time real estate values and stock market prices declined sharply together was 1974—a period of both recession and inflation.

That said, it's strange that bond prices are up and bond yields down despite the recent high inflation figures. One interpretation: Investors aren't worried about inflation. However, it could be that lower yields reflect a global flight to financial security rather than a lack of concern over higher prices.

The Fed, Wall Street, and Washington are primarily concerned about recession right now. The Fed's press release after the Jan. 30 Federal Open Market Committee meeting gives a strong impression that more cuts are coming: "[D]ownside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."

Yet it might not be long before inflation starts climbing a wall of worry. When that happens, expect to hear a lot more about the return of stagflation.

Farrell is contributing economics editor for BusinessWeek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace. His Sound Money column appears on BusinessWeek.com.