US economy: stagflation in America

Last week, swarajya made two key points with specific reference to a beleaguered US economy and the global economy in general.

Athat America was most likely headed for a period of stagflation, in which growth stagnated while inflation rose.

And, of themthat monetary policy alone would not be enough to remedy this situation.

These inferences were made based on a few interrelated observations, including an unexpected contraction in the US of 1.4% in the last quarter, inflation hitting 8.5% in March 2022 (the highest in decades), a rising US bond yields, which in turn drives up mortgage and lending rates, sluggish demand and a century-old disruption to the oil sector, caused by the West’s sanctioning of Russian energy exports because of the Ukrainian conflict.

In very general terms, the Joe Biden administration’s response to this crisis, so far, has been to raise the federal funds rate (FFR) to 1% by this week, making investments in America slightly more appealing. This is tied to an expectation that a rapid increase in US oil and gas production, primarily for export to Europe, would stimulate the economy and enable America to profitably replace oil and gas. the gas that Europe is currently buying in very large volumes from Russia.

The chances of success of this great plan are low and full of risks. (See here, here, here, here and here, for a five-part series on Biden’s big bet)

America is finally beginning to wake up to these truths, even if its institutions are not yet. However, a remarkably candid essay last week by Neel Kashkari, chairman of the Minneapolis Federal Reserve (much like a regional office of the Reserve Bank of India), marks the admission of a senior US Treasury official, that monetary policy may be insufficient to deal with the current economic crisis, as some of the root causes are beyond America’s control.

These include supply chain disruptions due to the ongoing epidemic containment in China and the conflict in Ukraine. For example, Adidas, the global sportswear giant, has lowered his expectations for 2022 and reduced its operating margin forecasts.

Kashkari did not delve into the demand side of things, or comment on the severity or impact of trade disruptions with Russia due to sanctions, but he does make a few points worth analyzing.

First, Kashkari believes that one way out of stagflation is to aim for a “neutral” FFR, which neither stimulates nor hinders the economy. According to him, this figure is 2%.

Second, it highlights a popular view among economists that the real FFR (nominal FFR minus inflation), which typically fluctuates between zero and minus two, is currently -6.4%. This sharp drop in the real FFR to record levels is due to record inflation.

The Federal Reserve is unable to keep up since “inflation has climbed faster than we have raised rates”. As a result, analysts say monetary policy has not tightened, but eased. “The Fed” would need to raise rates by 6-7% to catch up – which it cannot do.

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