The return of stagflation and the misery index

In the 1970s, in the wake of the international oil price crisis, the United States suffered from a prolonged period of high inflation and high unemployment, which came to be called stagflation. This prompted Arthur Okun, the late Brookings Institute economist, to develop a “misery index” to capture the economic pain experienced by the American public. The idea was simply to add the inflation rate to the unemployment rate to come up with a misery index as a single measure of economic pain. 

Today, with inflation rising to levels last seen 30 years ago and with unemployment remaining stubbornly high amid the COVID-19 pandemic despite massive policy stimulus, we may again be entering a prolonged period of stagflation that would merit the return of the misery index.

At the beginning of 2020, immediately before the pandemic’s onset, U.S. unemployment had declined to a 50-year low of some 3.25 percent as the Federal Reserve was having great difficulty in getting inflation to rise towards its 2 percent inflation target. This left us with an unusually low misery index of a little over 5 percent.

Two months after the pandemic began, unemployment skyrocketed to a post-war peak of 14.5 percent. Since then, in response to massive fiscal and monetary policy stimulus, the unemployment rate has declined appreciably, but it now appears to be stuck at around 5.25 percent. More troubling, consumer price inflation has now increased at a much faster pace than the Federal Reserve had predicted, and it too now stands at some 5.5 percent. The net upshot is that the misery index has more than doubled from its pre-pandemic low to its present level of almost 11 percent. 

In his recent Jackson Hole speech, Federal Reserve Chairman Jerome Powell painted a rather rosy economic scenario. He assured us that the current inflation pressures were the result of temporary supply-chain disruptions and labor market problems that would soon dissipate. That would allow inflation to return soon to the Fed’s 2 percent inflation target. He also expressed confidence that the labor market would continue to heal in response to the policy stimulus that the economy was receiving and that within a year or two the economy would return to full employment.

The delta wave that is hitting Asia particularly casts serious doubt on Powell’s assumption that the supply side problems causing inflation to rise will be short-lived. By forcing renewed economic lockdowns in important parts of the global supply chain such as Vietnam and Malaysia, the delta virus seems to be exacerbating manufacturing input shortage. Similarly, by forcing at least temporary shutdowns of major Chinese ports, the delta variant is adding to worldwide shipping costs.

Closer to home, the delta wave is contributing to the unevenness of the economic recovery, and it could be delaying the return of people to the workplace. We are already seeing signs of considerable slowing in the service side of the economy, including travel, restaurants and entertainment, at the same time that a highly stimulative budget and monetary policy is causing demand for manufactured goods to boom. We are also seeing signs of wage pressure as a record number of job openings exceeds the unemployment level. This threatens to add to inflationary pressures as rising demand for manufactured goods meets declining supply even at a time that the slowdown in the service sector will keep unemployment high.

The sad truth is that there is little that monetary policy can do about unemployment that is being caused by the delta variant, that is contributing to an uneven economic recovery and that is causing fear among at least parts of the public to return to the workplace. If the Federal Reserve disregards the limits of what its policy can do and continues to print money at a rapid pace, it could very well invite a prolonged period of stagflation. 

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.