Wednesday, February 22, 2017

It was the changing behavior of inflation that created stagflation

It's pretty simple, really. Stagflation is "not just inflation on the one side or stagnation on the other, but both of them together." That's according to Iain Macleod, who created the word and the concept of stagflation.

According to Wikipedia, the word stagflation is "a portmanteau of stagnation and inflation". Macleod took two separate and distinct words and jammed them together to make a new word to describe what he saw happening in the economy. In the economy, stagnation and inflation had been somehow jammed together so both were occurring at the same time.

I went to MeasuringWorth for real and nominal GDP from 2015 back to 1800. Annual data, unfortunately, but let's take a look. This graph shows years when prices were rising and GDP was not:

Graph #1: Annual Data Suggesting Times of Stagflation
Stagflation is not common, by this graph, though it was not altogether new in 1965 when Macleod gave it a name.

The graph shows annual data going back to 1800. A lot of people will tell you the data from back then is old, unreliable, and not worth bothering with. That's okay. They probably say the same about me.

I find it interesting that stagflation does not appear at all before the 1890s but does occur before World War Two. Knowing this, I want to take a look at the quarterly data. Quarterly data provides more detail than annual, like a camera with more megapixels. But the quarterly values begin in 1947, and provide no detail about earlier years.

This next graph shows the times since 1947 when RGDP growth was below half a percent and inflation was above 1%, for "change from previous quarter" values:

Graph #2: Quarterly Data Suggesting Times of Stagflation
My inflation measure is high, given that 1% quarter-to-quarter is used. I used "strongly rising" inflation, to borrow Macleod's phrase. The graph shows an interesting result. We see stagflation mostly in the 1970s: the beginning, middle, and end of the 1970s. Plus a couple years just before the 1970s and three years after. Call those 15 years an "era" of stagflation.

If I raise the "more than 1%" inflation filter to "more than 1.25%", the narrow, scattered bars disappear, leaving only the first blue bar on the left and the big cluster at the 1970s. That *is* when most of the inflation occurred, the 1970s. But that's not exactly the point. The point is that inflation was high in the '70s, and the economy was stagnant. The occurrence of both stagnation and inflation defines stagflation.

But then, most of the stagnation in and about the 1970s occurred as the result of inflation-fighting by the Federal Reserve. There were four rapid-fire recessions in that era, and no other recessions between March of 1961 and June of 1990.

The recessions "were basically brought on by the Fed, which raised interest rates sharply to curb inflation", according to Paul Krugman. That means the stagflation we see in that era was the result anti-inflation policy applied in a time of high inflation.

Inflation was running high in those years, and the policy response to inflation created stagnation. The policy response did reduce inflation, but not enough to make prices fall. This meant we had both inflation and stagnation, which by definition is stagflation.

The key point is that inflation was rising strongly. Anti-inflation policy was the natural response. The response created stagnation. Unless prices actually fell, the result was stagflation.

I like this explanation. But I think most people, if you asked them about stagflation, would say it happened because of the oil shocks. The dramatic increases in the price of oil. Well, okay. The oil shocks of 1973 and 1979 might explain the stagflation in the middle '70s and the stagflation at the end of the '70s. But what about the stagflation at the beginning of the '70s? That was before any oil shock, yet there it is on Graph #2, plain as day. So the "oil shock" story does not fully explain stagflation.

The next graph shows the monthly change in prices, as measured by the CPI. The blue line does seem to move downward at or near times of recession. So the rate of inflation goes down. But in the stagflation era, prices didn't go down. On this graph, the blue line going below zero indicates prices going down:

Graph #3: Percent Change in the CPI (monthly data)
Over time, between the 1940s and the 1960s, the blue line goes below zero less and less. In the latter 60s the blue line stops going below zero altogether, till after the 1982 recession. In those years, prices did not go down. So from the latter 1960s to 1982, any time the economy was stagnant we had "stagflation".

The "percent change" in CPI did vary, of course. And the economy continued to have recessions. But stagnation no longer coincided with price decline, because prices no longer went down. In the stagflation era, prices went up a little more or went up a little less, but did not go down. This seems to me to be the simplest explanation of stagflation.

If this explanation is correct, it was the changing behavior of inflation that made stagflation a reality. Instead of going up or down, prices went up more or up less. You can see it on the graph. To explain this different behavior, we should look at inflation before and during the stagflation era. Since the problem was that inflation didn't go below zero -- it didn't go low enough, in other words -- we should look at the lows of inflation, not the highs.

The trend of low values of Graph #3 is persistently upward from the mid-1950s (or earlier) to 1980, as shown here:

Graph #4: Same as Graph 3 up to 1988 (blue), the Lows of the Blue line (red),
and Overlapping Three-Year Averages of the Red Line (black)
The problem that became stagflation began as gradually increasing inflation. It was developing already the first time inflationary lows bottomed out at a higher level than they had before. When was that first time? The lows of the 1970s were higher than the low of the 1960s. But the low of the 1960s was higher than the low of the mid-50s. And I'll be damned if the low of the mid-50s wasn't higher than the low of the late '40s.

Stagflation emerged late in the pattern of long-term increase visible in the inflationary lows. This is not a problem that began in 1974. It is not a problem that reduces to slow growth in AS. And it is not a problem that can be written off as inflation expectations. It may, however, be attributed to a gradual, long-term, cost-push problem such as the one arising from the persistent growth of finance.

The stagflation era is a benchmark in economic history. It is fully explained by the long-term increase in inflationary lows that goes back 30 years or more before 1980. That long-term increase is not fully explained by the price of oil.

In his 1957 lectures on Prosperity Without Inflation, Arthur Burns eloquently explained that economic policies since the enactment of the Employment Act of 1946 had introduced an inflationary bias in the U.S. economy ...

The Excel files

USGDP_1800-2016.xls for Graph #1

Stagflation Quarterly.xls for Graph #2

Lows in Percent Change of CPI.xls for Graph #4

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