Stagflation Ahead?

America is facing an economic downturn now with slow economic growth and rising unemployment. Recent economic indicators point to the possibility of stagflation -- a slowdown in economic activity combined with rising prices not seen since the 1970s.

Many predicted that a recession is forthcoming. Yet, economists for UBS Bank said in a recent research report that "it is not coming, it is here". The bank estimates that the U.S. economy is in a mild recession already.

Spending is deemed as the primary engine of the economy, accounting for more than two-thirds of GDP of the U.S. Yet, earlier report on the economy' s performance in the first quarter released recently by the Commerce Department showed that consumption is at its weakest point since the recession of 2001. It is expected that spending will go up slightly after the government mails out tax rebates in an effort to stimulate the economy later this month. However, many economists believed that the coming rebates can only help to alleviate the crisis temporarily, but are not likely to prop up sales for long, as Nigel Gault, chief United States economist at Global Insight has pointed out: "Any burst of spending based on the stimulus payments is likely to short-lived"

The crisis poses a dilemma for the Fed as well. On one hand, it tries to use an expansionary monetary policy to fight for recession, while on the other hand, it has to keep price pressures in check as there are signs of inflation in the air brought by the high food and energy prices.

Construction and manufacturing sectors also show the sign of recession, "as residential construction fell sharply in March, shrinking 4.6 percent as builders cut back on groundbreakings or stopped work on projects". Mean while, "manufacturing activity stayed flat in April as companies laid of workers"

Economists therefore believe that unemployment rate will also rise consequently. In fact, unemployment rate has slipped to 4.9% in January, and there was a net loss of 17,000 jobs in the same month, according to the Labor Department reading. Financial forecast center even forecasted that the number would jump to 5.2% in May.

Theoretically speaking, stagflation will pose a serious dilemma for the central bank, as policies that are usually used to increase economic growth will further increase runaway inflation while policies used to fight inflation will further the decline of an already-declining economy. Therefore, some say that it is an impossible task for the Fed to find a perfect interest rate in a stagflation scenario to solve the problem effectively.

In history, stagflation hit most of the developed world and the United States in the 1970s. President Richard Nixon was so concerned about 4 percent inflation in 1971 that he imposed wage and price controls to reign in it. So what were the presidential candidates' reactions to this potential stagflation? Senator Barack Obama addressed the issue in a speech in February. He said:"I won't just raise the minimum wage every 10 years. I want to raise it every year to keep pace with inflation, because if you work in America, you should not be poor". Senator, John McCain, however, blamed overspending by the federal government in part for the nation’s economic troubles. He said in January:“As a Republican, I stand before you embarrassed. Embarrassed that we let that spending get out of control...The economy is not good. The stock market continues down. And the indicators are not good. I’m not too astonished…. We let spending get totally out of control, and it continues today, and I’m sorry to tell you this,” However, government spending seems to have nothing to do with economic growth. Government spending, instead, historically promoted economic growth.

Source: NYTimes, PBS, ABCNews