The return of stagflation?

America is no stranger to stagflation. In the second half of the 1970s and early 1980s, we suffered from the unwelcome combination of high inflation, sluggish economic growth and high unemployment. We did so as the country suffered from two major oil supply shocks that sent international oil prices soaring.

Today, there is a real risk that we will return to the stagflation of the past but for a different reason than in the 1970s. This time around it might be the result of excessively loose budget and monetary policies combined with continued supply disruptions both at home and abroad. Those supply disruptions might intensify as a result of the spread of the Delta COVID-19 variant that is already wreaking havoc in several countries.

The stagflation risk is underlined by recent economic data. Consumer price inflation has risen to 5 percent, its highest level since 2008, even as unemployment remains stuck at around 6 percent, far from its full employment level. 

The main risk that today’s inflation will prove to be anything but transitory stems from the unusually easy stance of budget and monetary policy. It also stems from the likely release of the considerable amount of pent-up demand that was built up during the pandemic’s lockdown phase.

One way to gauge this risk is to consider the size of the budget stimulus in relation to the gap between the current U.S. output level and its full employment level. Combining the December 2020 bipartisan stimulus package with the March 2021 Biden American Rescue Plan, it turns out that this year the U.S. economy will receive a record peacetime budget stimulus amounting to a staggering 13 percent of GDP. That stimulus is around four times the Congressional Budget Office’s estimate of the current output gap, which must raise the specter of economic overheating by yearend. 

Adding to the specter of overheating is the continued extraordinarily easy monetary policy stance. As a result of the Federal Reserve’s continuing to buy $120 billion a month in Treasury Bonds and mortgage-backed securities, interest rates remain at ultra-low levels, housing and equity prices are soaring and the broad money supply continues to grow at by far its fastest rate in the past 40 years. Adding fuel to the rapidly increasing aggregate demand is the fact that households are now beginning to draw down the $2.6 trillion in excess savings that they are estimated to have built up during the lockdown phase.

The key risk that higher inflation will continue to be accompanied by high unemployment is that the Delta variant might spread rapidly both at home and abroad. Underlining this risk are the facts that this variant is much more infectious than the earlier COVID strains and that the vaccines seem to be less effective in protecting the vaccinated public against this particular strain than against the original strain. 

Should the Delta variant take hold abroad, it could prevent the repair to the current global supply chain disruptions. In particular, it could keep both food and industrial materials in short supply, and it could exacerbate the current shortage in electronic chip production that is so vital to modern manufacturing production. Worse yet, should the Delta variant spread in the United States, it could keep schools closed and it could delay the full return of people to work. 

The heightened risk to the supply-side of the economy adds urgency for policy changes to rein in the current degree of excess demand if we are to avoid a prolonged period of inflation. It supports the idea that the Federal Reserve should immediately dial back its ultra-easy monetary policy stance. It also supports the idea that the U.S. economy can ill afford any further budget stimulus and that any plan to increase public infrastructure spending must be fully financed by appropriate tax increases. 

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.