The Return of Stagflation

By RONALD MCKINNON, WSJ

'Stagflation" is an ugly word for an ugly situation: persistent high inflation combined with high unemployment and stagnant demand in a country's economy. The term was coined by British politician Iain Mcleod in a speech to Parliament in 1965. We haven't experienced it here in the United States since the bad old days of the 1970s.

Yet with prices on the rise and unemployment still high, the U.S. economy again seems to be entering stagflation. April's producer price index for finished goods, which excludes services and falling home prices, rose 6.8%. The Bureau of Labor Statistics reports that intermediate goods prices for April were rising at a 9.4% annual clip. Meanwhile the official nationwide unemployment rate is mired close to 9%, without counting a large backlog of discouraged workers who are no longer officially in the labor force. So stagflation it is.

Although many forces buffet the U.S. economy, the near-zero interest rate policy of the Federal Reserve is the prime contributor to the current bout with stagflation.

Since 1945, most of the world has been on a dollar standard. Today, for emerging markets outside of Europe, the dollar is used for invoicing both exports and imports; it is the intermediary currency used by banks for clearing international payments, and the intervention currency used by governments. To avoid conflict in targeting exchange rates, the rule of the game is that the U.S. remains passive without an exchange-rate objective of its own.

Not having an exchange-rate constraint, the Fed can conduct a more independent monetary policy than other central banks can. How it chooses to exercise this independence is crucial to the stability of the international monetary system as a whole. For more than two years, the Fed has chosen to keep short-term interest rates on dollar assets close to zero and—over the past year—applied downward pressure on long rates through the so-called quantitative easing measures to increase purchases of Treasury bonds. The result has been a flood of hot money (i.e., volatile financial flows that are subject to reversals) from the New York financial markets into emerging markets on the dollar's periphery—particularly in Asia and Latin America, where natural rates of interest are much higher.

Wanting to avoid sharp appreciations of their currencies and losses in international competitiveness, many Asian and Latin American central banks intervened to buy dollars with domestic base monies and lost monetary control. This caused a surge in consumer price index (CPI) inflation of more than 5% in major emerging markets such as China, Brazil and Indonesia, with the dollar prices of primary commodities rising more than 40% world-wide over the past year. So the proximate cause of the rise in U.S. prices is inflation in emerging markets, but its true origin is in Washington.

There is a second, purely domestic avenue by which near-zero interest rates in U.S. interbank markets are constricting the economy. Since July 2008, the stock of so-called base money in the U.S. banking system has virtually tripled. As part of its rescue mission in the crisis and to drive interest rates down, the Fed has bought many nontraditional assets (e.g., mortgage-backed securities) as well as Treasurys. Yet these drastic actions have not stimulated new bank lending. The huge increase in base money is now lodged as excess reserves in large commercial banks.

In mid-2011, the supply of ordinary bank credit to firms and households continues to fall from what it had been in mid-2008. Although large corporate enterprises again have access to bond and equity financing, bank credit is the principal source of finance for working capital for small and medium-sized enterprises (SMEs) enabling them to purchase labor and other supplies. In cyclical upswings, SMEs have traditionally been the main engines for increasing employment, but not in the very weak upswing of 2010-11, where employment gains have been meager or nonexistent.

Why should zero interest rates be causing a credit constraint? After all, conventional thinking has it that the lower the interest rate the better credit can expand. But this is only true when interest rates—particularly interbank interest rates—are comfortably above zero. Banks with good retail lending opportunities typically lend by opening credit lines to nonbank customers. But these credit lines are open-ended in the sense that the commercial borrower can choose when—and by how much—he will actually draw on his credit line. This creates uncertainty for the bank in not knowing what its future cash positions will be. An illiquid bank could be in trouble if its customers simultaneously decided to draw down their credit lines.

If the retail bank has easy access to the wholesale interbank market, its liquidity is much improved. To cover unexpected liquidity shortfalls, it can borrow from banks with excess reserves with little or no credit checks. But if the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield. And smaller banks, which collectively are the biggest lenders to SMEs, cannot easily bid for funds at an interest rate significantly above the prevailing interbank rate without inadvertently signaling that they might be in trouble. Indeed, counterparty risk in smaller banks remains substantial as almost 50 have failed so far this year.

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. Without more lending to SMEs, domestic economic stagnation will continue even though inflation is taking off.

The stagflation of the 1970s was brought on by unduly easy U.S. monetary policy in conjunction with attempts to "talk" the dollar down, leading to massive outflows of hot money that destabilized the monetary systems of America's trading partners. Although today's stagflation is not identical, the similarities are striking.

Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.