Stagflation vs. Sagflation

In an editorial by Mr. Ronald McKinnon in the WSJ, he argues we have entered a period of stagflation. This period is marked by high inflation, low economic growth, and high unemployment. He seems to somewhat cherry-pick his data to fit his thesis since he uses PPI of 6.8% and the prices in foreign countries to support his inflation claim, avoiding the housing, wages, and CPI. He argues the central reason for inflation is: "the proximate cause of the rise in U.S. prices is inflation in emerging markets, but its true origin is in Washington." His central reason is "Since July 2008, the stock of so-called base money in the U.S. banking system has virtually tripled." He goes on to argue the printing of money and low interest environment created by the Fed has exported inflation to emerging markets, a point on which I agree.

However, he seems to then bend himself into a pretzel as he argues that the low interest rates are creating credit constraint, which should drive deflation not inflation.

"That the American system of bank intermediation is essentially broken is reflected in the sharp fall in interbank lending: Interbank loans outstanding in March 2011 were only a third of their level in May 2008, just before the crisis hit. How to fix bank intermediation is a long story for another time. But it is clear that the Fed's zero interest-rate policy has worsened the situation."

In the end he seems to argue it both ways, easy money is the cause of inflation and weak economic growth, thus stagflation. A pretzel of an argument that fails to identify fundamental causes or a pathway forward.

Under my Sagflation thesis, I argue many of the fundamental economic trends in the future are likely deflationary, including technological advances, high debt levels, and over-supply of housing and retail space. Offsetting these deflationary pressures is an aggressive Federal Reserve that appears hellbent on avoiding deflation. The loser in this equation is price stability, as witnessed in bubbles in specific market segments and foreign economies.

Our pathway going forward is to work off the excess capital, re-focus investments on higher return projects, and reduce debt. Until then, we are in a low return environment that will make sustainable economic growth difficult. Working through these issues could happen gradually over ten to twenty years or could occur in less than five, depending how dramatic we want to make it.