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The US economy seems to have reached a critical point where recession may be accompanied by inflation, a situation that is extremely difficult for the Fed to manage. Such a condition is termed as stagflation. And just what the hell is stagflation – Is it some special kind of stag released by the economy? It is actually a term coined by economists and is loosely defined as a period of slow economic growth and relatively high unemployment accompanied by a rise in prices, or inflation.

The signs for such a recipe seem to be in the making for the US economy. The US Labor Department recently announced that consumer prices in the nation had jumped 0.4% in January, which was nearly 4.3% higher than the prices a year ago. Unemployment has also started to raise its ugly head and latest numbers indicate that it has risen to about 4.9%.

Any central banker faces a dilemma under these conditions. Under ordinary circumstances, a central bank could lower interest rates to spur the economy and fight unemployment. Alternatively, the central bank has the option to raise interest rates to fight inflation and rising prices. Oops! Right now the Fed may need to fight both together – sounds like a dilemma indeed!

The US experienced the symptoms of stagflation during the decade starting 1970, when inflation peaked to almost 15% and unemployment touched a high of 9%. Though, the present rates of inflation and unemployment are much more moderate compared to the rates in the 70s, the dilemma appears to be the same. The moderation in the rates indicates that the economy has matured substantially. An economy may be termed as mature when it is marked by low unemployment and low inflation rates, which are manageable cyclically. The combination of the present inflationary trend and increasing unemployment rate lead to a situation that is more difficult for the Fed to manage. The combination of these two movements also challenges the key assumption that the US economy can grow without generating inflation.

US Fed

So what are the options that the US Fed is left with to fight stagflation? Will it raise interest rates to fight inflationary expectations or will it lower interest rates to spur the economy and generate employment. Alternatively, the Fed might adopt a wait and watch stance and keep the interest rates unchanged for some time.

Fed’s Options

Raise interest rates

If the Fed raises interest rates, it may squeeze out liquidity from the economy and manage to dampen price increase. However, raising interest rates is likely to make money more expensive for industry and will squeeze economic growth further. Unless inflation shows signs of shooting up, the Fed is unlikely to adopt this option.

Lower interest rates

Given the existing macroeconomic scenario of weak growth, the real estate market being stumped by high interest rates and rising unemployment, the Fed’s choice may be to lower interest rates. This will be based on the projections for inflation and if the projection is moderate, the Fed may resort to slicing interest rates just one more time.

Keep interest rates unchanged

The Fed having lowered interest rates twice in a row in January 2008, could possibly adopt a wait and watch situation and leave interest rates unchanged.

This move will imply that the Fed is not addressing either the issue of fighting inflation or inducing industry to invest more, which could have led to enhancement of employment