Stimulus Complete: Now Comes New Economic Nightmare in Stagflation
The US economy has received an unprecedented amount of stimulus from the federal government and the Federal Reserve in response to the coronavirus pandemic. The total amount of stimulus spending reached $5.2 trillion, equivalent to about 24% of the GDP in 2020. The stimulus was intended to support households, businesses, and state and local governments during the crisis and to boost the economic recovery.
However, some economists and analysts are warning that the stimulus could have unintended consequences for the economy in the long run. One of the most feared scenarios is stagflation, a situation where the economy faces both high inflation and low growth at the same time. Stagflation is considered an economic nightmare because it is difficult to solve with conventional monetary and fiscal policies.
What causes stagflation and why is it a risk for the US economy According to one theory, stagflation can be triggered by a sudden increase in the cost of oil or other essential commodities that reduces the productive capacity of the economy. This happened in the 1970s, when an oil embargo by OPEC led to a quadrupling of oil prices and a global recession. The US economy experienced stagflation from 1973 to 1975 and again from 1979 to 1982, with inflation reaching double digits and unemployment rising above 10%.
Another theory suggests that stagflation can result from excessive stimulus that creates demand-pull inflation, where aggregate demand exceeds aggregate supply and pushes up prices. This can happen when the government runs large budget deficits and monetizes them by printing money, or when the central bank keeps interest rates too low for too long and fuels asset bubbles and credit expansion. This happened in the late 1960s and early 1970s, when President Lyndon Johnson's Great Society programs and the Vietnam War increased government spending and inflation expectations, while the Fed failed to tighten monetary policy sufficiently.
The current situation in the US economy has some elements of both theories. The pandemic has disrupted global supply chains and caused shortages of various goods and services, from semiconductors to lumber to labor. This has driven up input costs and consumer prices, with inflation reaching 5.4% in June, the highest level since 2008. At the same time, the massive stimulus has boosted consumer spending and savings, creating pent-up demand that could outstrip supply as the economy reopens. The Fed has maintained its ultra-easy monetary policy stance, keeping interest rates near zero and buying $120 billion worth of bonds per month.
While some economists argue that the current inflation spike is transitory and will fade as supply bottlenecks are resolved and base effects wear off, others warn that inflation could become persistent and entrenched if expectations rise and wages follow suit. Moreover, if the economy fails to sustain its robust growth momentum as the stimulus wears off and faces headwinds from new virus variants, higher taxes, or geopolitical tensions, then stagflation could become a real threat.
How can stagflation be avoided or overcome The key is to balance the demand and supply sides of the economy and to anchor inflation expectations at a reasonable level. This requires a careful calibration of monetary and fiscal policies, as well as structural reforms to enhance productivity and competitiveness. The Fed should communicate clearly its inflation target and its strategy to achieve it, while being ready to adjust its policy stance if inflation persists or growth falters. The government should prioritize quality over quantity of spending, focusing on public investment in infrastructure, education, research, and innovation that can boost long-term growth potential. The private sector should also play a role in fostering innovation, competition, and efficiency in various industries.
Stagflation is not inevitable, but it is not impossible either. The US economy faces significant challenges and uncertainties in the post-pandemic era. It is crucial to learn from history and avoid repeating past mistakes that led to stagflation in previous decades. aa16f39245