Should You Worry About Stagflation?

Inflation hawks say if the United States continues its current path, stagflation could return.

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In November 2010 when the Federal Reserve launched its latest round of quantitative easing—known as QE2—it cited concerns that without more stimulus, the country could slip into a deflationary environment of falling prices. But after months of Fed bond buying, critics say the program is causing inflation, most notably in oil prices. Now, some experts are concerned that higher fuel and food prices, coupled with slower-than-expected growth in the United States, may cause a different type of economic phenomenon: stagflation.

Stagflation occurs when a slowdown in economic growth combines with a rise in inflation. The last time the United States experienced a serious bout of stagflation was in the 1970s, amid a similar oil-price shock, inflation in the low double-digits, and a depressed economy. Inflation hawks say if the United States continues its current path, stagflation could return.

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"I think it's probably the biggest unspoken concern of those of us that consider ourselves cautious or bearish," says Jeffrey Sica, chief investment officer of Morristown, N.J.-based investment firm SICA Wealth Management. "Stagflation is a real possibility that's not discussed much."

Sica points to first-quarter GDP numbers, which showed the U.S. economy is growing at a sluggish rate of 1.8 percent. That's slower than the fourth quarter of 2010, when it grew at a more robust rate of 3.2 percent. Much of the slowdown in growth was attributed to higher food and oil prices.

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In March, the Consumer Price Index (CPI), which measures the average change in prices of goods and services over time, rose 0.5 percent. Over the past year, the CPI has risen 2.7 percent, driven primarily by energy and food prices. The CPI's gasoline index rose 5.6 percent in March and has increased 14.4 percent over the last three months. That increase has contributed to higher prices at the gas pump. The national average price of regular unleaded gasoline is $3.96, up 32 cents from a month ago, and $1.07 from a year ago, according to AAA.

When the Federal Reserve measures inflation, it focuses on what it calls "core inflation," which strips out food and energy prices because they can be extremely volatile and hard to predict at times. (Core inflation rose only 0.1 percent in March, and over the past year it has increased just 1.2 percent.) Sica says it's a mistake to ignore that. "[Commodity prices] have a greater impact than the Fed is giving credit," he says.

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Aside from food and energy prices, it's important to consider the prices of other goods and services such as housing and wages, says Greg Woodard, portfolio strategist with Rochester, N.Y.-based Manning & Napier Advisors. "Most people think of inflation as broad-based inflation—all prices of services and goods of the economy go up," Woodard says. While rising costs do affect consumer spending, Woodard says he believes the prospect of stagflation is unlikely.

That's because when economists typically refer to stagflation, it also involves rising wages. Woodard says real inflation involves higher prices along with higher wages. That creates what's called a "wage-price spiral," in which rising prices force people to demand higher wages. "That creates this cycle of higher and higher costs," Woodard says.

With an unemployment rate still close to 9 percent, it's hard to see wage inflation in the near future, says Woodard. "It's very difficult to have workers be able to actually demand higher wages when you have 9 or 10 percent unemployment," he says. "It would be very difficult to see a wage-price spiral develop in this type of economic environment."

Twitter: @benbaden