Main Street 9

Investors looking for a silver lining to the weak jobs picture in the United States should consider this: the recent rise in unemployment may move the U.S. further away from the danger of stagflation.

At least that will be the case if the historical relationship between the jobless rate and inflation holds up. It suggests that annual consumer price growth rarely surpasses the unemployment rate for long.

The last two times it did so on a protracted basis coincided with the stagflationary periods of low growth and high inflation during the 1970s and 1980s. Recently, the two measures have gotten close, but not crossed over.

Analysts say this spread is not an indicator they track, though it does reflect inflationary shocks, such as surging oil prices that can push up costs throughout the economy.

“That’s kind of like the old misery index,” said Carl Lantz, U.S. interest rate strategist at Credit Suisse in New York.

“You get periods like this where inflation and unemployment are both rising when there are things like commodity-price, cost-push inflation.”
MISERABLE

The misery index Lantz refers to is the unemployment rate added to annual inflation rate. It is based on the notion that a worsening of both has a wide range of effects on the economy and well-being of consumers.

The measure, which goes back to 1948, reached an all-time high in 1980, when the economy was last in the grips of stagflation. That was also when inflation recorded its biggest jump over unemployment in the last 60 years, with the rate of consumer price growth accelerating to 8.5 percentage points more than the jobless rate.

At that time, in March 1980, annual consumer price inflation was an extraordinary 14.8 percent and unemployment was 6.3 percent. The misery index peaked at 21.98 in June 1980.

More recently, the jobless-inflation spread narrowed to half a percentage point in June, when annual consumer price growth jumped to 5 percent, close to an unemployment rate of 5.5 percent.

Unemployment rose to 5.7 percent in July. Last month’s inflation data have yet to be announced but could show a drop, given the recent retreat in oil prices from record highs.

A moderation of inflation accompanied by higher unemployment would be the traditional reaction to deteriorating economic conditions. That is still the solution many analysts see to the current elevated rate of price growth.

“The slow growth we are seeing right now will offset the effects of energy prices and rising import prices and keep underlying inflation relatively stable,” said Mike Moran, chief economist at Daiwa Securities in New York.

BAD NEWS IS GOOD NEWS

Those who expect inflation to fall have history on their side. Recessions have a reliable record in killing inflation, though the point at which price growth retreats can vary from the beginning, middle or the end of economic weakness.

The current U.S. downturn has not yet been determined to be a recession. But chances of this rose when revised data last week showed the economy shrank in the fourth quarter of 2007.

For inflation vigilantes, the question is, what happens in the meantime? Recessions in the 1960s and 1970s turned inflation back, but the rate of price growth tended to decline to a higher base and reach loftier peaks the next time around.

In 1981, the Federal Reserve raised interest rates to an astounding 19 percent to stop inflation, which then declined for two decades. Currently, its benchmark rate is 2 percent.

Most analysts don’t consider the current episode to be stagflation. But they say the Fed could face huge pitfalls if price pressures get worse from here, since raising interest rates could damage a financial sector already reeling from the worst housing slump since the Great Depression.

“It’s a challenging period for monetary policy-makers because if inflation moves up a little bit in the second half of the year and growth is sluggish, they are kind of caught between a rock and a hard place,” said Joel Prakken, chairman of Macroeconomic Advisers.

Prakken said he would not give credence to the inflation-unemployment spread as an economic indicator, but to anyone who might, he has an upbeat outlook.

“I will boldly make the prediction that inflation will not go above the unemployment rate in this cycle,” he said. “The unemployment rate … will probably go up further toward 6 percent and I don’t expect inflation to be anywhere close to 6 percent.”