Stagflation Is Likely Coming To The U.S. Economy

From the pen of economist Paul Krugman:

Sometimes the state of the economy offers clear guidance on what policies should be undertaken. And, in the short term, the policymakers who make those decisions are at the Federal Reserve. Yes, fiscal policies – taxes and government spending – also have significant effects on the economy. But fiscal policy is slow to change – typically, it requires passing legislation. In contrast, the Fed can have an immediate effect on the economy by lowering or raising the Federal Funds rate – the short-term rate that the Fed has direct control over. Since fiscal policy can only be implemented with long time lags, it’s basically the job of the Fed to keep the economy on an even keel.

When the inflation rate is low but the unemployment rate is high, as it was during the Great Recession in the aftermath of the 2008 financial crisis, the Fed should cut the federal funds rate. By lowering the fed funds rate, the Fed makes it cheaper for banks to lend. This boosts the spending and investing activity in the economy and brings unemployment down.

When inflation is high but unemployment is low – that is, when the economy is at risk of overheating -- as it was in 2022, the Fed should raise the fed funds rate. This slows down spending and investing and brings inflation down.

But when the unemployment rate and the inflation rate are both too high — what economists call “stagflation” — the Fed faces a dilemma. Cut the fed funds rate ratesto support employment and you risk worsening inflation. Raise the fed funds rate to fight inflation and you risk raising unemployment. With stagflation, there are no easy answers, just a tradeoff of risks.

And this dilemma looks very relevant right now: many economic indicators suggest that the United States will soon undergo at least mild stagflation.