If you keep track of economic news these days, you notice that the word stagflation is frequently uttered by newscasters and economic analysts. This term was coined by economists to describe an unconventional phenomenon that took place in late 1970s: the simultaneous occurrence of high unemployment and high inflation. The combined unemployment rate and inflation rate, properly called the misery index, averaged over 17% from 1974 to 1981. It has been nearly 8% since 1993.
What fuels the current inflationary expectations is the increasing commodity prices. Paradoxically, prices of strategic commodities has been going up despite economic slowdown as investors are moving away from the volatile stock and bond markets and pouring their money into safer commodities. They believe that, given the risk, financial assets are overpriced hence unattractive means of investment. In addition, innovative products, such as exchange-traded funds, allow investors an easier and a more direct access to a broad range of low risk commodities. If, and only if, the effects of these factors are long lasting, it will eventually create overall inflation as producers pass on the higher costs of production to their customers in the form of higher prices.
However, the Federal Reserve believes that the fear of inflation is not sustainable because it is based on a hastily rise in commodity prices that should be temporary and mainly caused by speculation. Institutional investors are moving their funds into commodities to hedge against inflation and there is no real demand pressure in the commodity market. If such speculative transactions decelerate according to the Fed, the rate of inflation should decline. Furthermore, wage rates are not going to increase because of an ongoing economic slowdown and the sluggish but steady rise in unemployment rate which is expected to continue throughout this year and possibly next year. Historical evidence shows that prices have declined eventually during and even after each economic downturn.
The current inflationary fear was also exacerbated by the abrupt increase in the reported inflation rate to about 4.3% - an annualized rate for 2008 based on the inflation rate calculated for the month of January. This was surprisingly unexpected by analysts after so many years of a moderate rate of inflation, steadily below 3%. The Fed also believes that the sudden jump in price level for the month of January may not be a good indicator of long term inflation. Fed considers the core rate of inflation as a better predictor of the long-term outlook. This rate is calculated after excluding the effects of the most volatile components, food and energy, from the overall rate. The core rate is currently equal to 2.3%.
Moreover, the unprecedented decline in price of housing, nearly 9% compared to the same time last year according to Standard & Poor’s estimate, may help to ease off the inflationary pressures. This will happen eventually if the Bureau of Labor and Statistics modify its future calculations of the overall rate of inflation to reflect the lower cost of housing.
To summarize, I believe American consumers are not expecting a persistent excessive increase in the overall price level yet because the primary causes of the latest surge in inflation rate are hopefully short-lived.
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