Stagflation, dare I say it?

I've been familiar with the term
Amey Stone

I've been familiar with the term "stagflation" for years and understand well that it describes a disastrous economic condition where growth is stagnating, but inflation is climbing. But I think today was the first day I actually said the word aloud.

What prompted me to talk about such a troubling -- and farfetched -- scenario? It was today's report that gross domestic product grew just 3.1% in the first quarter. Economists were expecting 3.5% growth. It's increasingly clear that both businesses and consumers have slowed their spending -- at least for everything except real estate --at the same time that prices across the board have continued to rise (mainly due to higher oil).

Do I think we're headed into a period of stagflation? Certainly not. But I'm starting to see how one could arise. And that's pretty scary in and of itself.

The economic commentary I read can be divided between those who think the soft patch is only temporary (and that the Federal Reserve can raise rates further without doing much harm) and those who think the economic recovery is waning and that the biggest risk is that the Fed will keep raising rates, effectively slamming on the economic brakes and throwing the country into recession.

Either way, it's clear the Fed has a tough job at its May 3 meeting. This analysis from Dean Baker, Co-Director of the Center for Economic and Policy Research in Washington, D.C., sums up well the challenge today's GDP report presents for the Fed:

This report will have to be very worrying to the Fed. The hope for the recovery was always that a strong upturn in investment, ideally going along with an improvement in the trade balance, would offset the inevitably weakening of borrowing-driven consumption growth and the housing boom. At this point, the housing boom is presumably reaching an endpoint, and consumers are being stretched very thin, as savings rates move ever closer to zero. However, investment appears to be weakening, rather than strengthening and the trade deficit continues to grow.... The Fed will be left with the choice of trying to keep interest rates low to help sustain growth, or raising interest rates in an effort to choke off inflation.
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