(Trends Wide Business) — There’s no denying it: inflation is here. Consumer prices increased 7% over the past year. House prices have also continued to rise. But the question on the minds of many Wall Street economists and strategists is whether something even worse could be on the cards: Prices rise as the economy slows. That is the textbook definition of stagflation, and it would be the worst nightmare for consumers, investors and the Federal Reserve, the Fed.
Not to mention President Joe Biden and the rest of the Democratic leadership in Washington. Just ask former President Jimmy Carter, who lost to Ronald Reagan for re-election in 1980 when the economy was suffering from rising gas prices.
Stagflation is a difficult problem to overcome, especially for central bankers at the Fed and the rest of the world. There are few tools to fight inflation and the slowdown at the same time. The strongest solution to an economic downturn is to lower interest rates, but they have been near zero for almost two years.
Raising rates to fight inflation, as the Fed said it might do soon, could slow the economy. That’s a big concern right now in the UK, where central bankers raised rates last month to combat higher prices.
Rate hikes also tend to put more pressure on long-term bond yields, which have already risen in anticipation of the Fed’s action. These tend to be partly inflationary because they make it more expensive to borrow money.
The good news is that the economy continues to grow at a healthy pace as it recovers from the pandemic downturn. Consumers continue to spend. And even if the Fed does start to raise interest rates, it is unlikely to do so at such a rapid pace or scale that it will cause too much damage to the economy in the short term.
“There is enough stimulus in the system to not worry about the ‘fired’ part of this equation for many quarters to come,” Jim Reid, Deutsche Bank’s global head of thematic research, said in a report last week.
The increase in prices, an economic setback or a nightmare?
However, growth slowed in the third quarter, raising some alarm bells. The market expects the economy to recover in the fourth quarter and continue to do so through 2022.
Still, lingering supply chain concerns and rising cases of the omicron variant of Covid-19 could dash hopes of a recovery.
That raises the chances that the Fed could misjudge the timing and tighten policy too aggressively if it starts to worry about the price stability (inflation) part of its dual mandate rather than the maximum employment (jobs) part.
“There is always the risk of a policy error. The Fed carries a nuclear monetary policy ball with them, so there is a possibility of an error,” said Kristina Hooper, chief global market strategist at Invesco.
That said, Hooper isn’t too concerned that Fed Chairman Jerome Powell is about to make a big monetary mistake.
“You always want to look out for something like stagflation, but we don’t have high unemployment right now and economic growth is above trend,” he added. “Are we at risk of stagflation in a rising rate environment? Yes, but unlikely.”
The Fed is in uncharted territory. Central bankers have had to deal with many crises in recent decades, but there is no modern playbook for how to handle the threat of runaway inflation after a global pandemic.
“The Fed’s monetary policy framework is essentially being tested in real time,” said John Leer, chief economist at Morning Consult, a data intelligence firm. “There’s not a lot of guidance.”
Spending remains strong despite inflation
At this point, it appears that rising prices are more of a source of consumer complaints and alarmist headlines than, as yet, a serious economic concern.
That’s why experts say investors need to be on the lookout to see if consumers actually cut back on spending because of inflation. That’s when it would be time to worry about stagflation.
“Consumers may get to a point where they won’t pay higher prices and that will lead to demand destruction. We’re not there yet,” said Mike Skordeles, US macro strategist at Truist Financial. “Stagflation could be a concern if higher prices persist for an extended period.”
Skordeles also believes that stagflation concerns are “misplaced” at the moment because growth is still relatively strong and the market has confidence in the Fed.
So as long as retail sales remain strong, it can be argued that while shoppers aren’t laughing at inflation, they are bearing it for now.