What shape will the economic recovery take?  The economic forces that are building combined with the political incentives facing policymakers make a return to stagflation a leading scenario.

For those too young to remember the late seventies, stagflation is a combination of economic stagnation and inflation.  Traditional macroeconomic thought did not expect stagflation prior to its emergence in the Carter years.  Typically the most significant volatility in the economy is in aggregate demand.  Historically, periods of stagnation or recession are associated with lower aggregate demand and periods of inflationary pressures are associated with an over stimulated aggregate demand.  In the sixties some economists even speculated we would reach the point of fine tuning economic policy to manage the tradeoff between periods of unemployment and inflation.  Then, during the late seventies slow economic growth with persistent high unemployment while at the same time the economy suffered from rising prices and inflation. 

In order for stagflation to occur there must be some dampening effects on production and aggregate supply within the economy that will limit the ability of growth to take place.  At the same time there must be a simulative monetary policy to feed the inflationary environment.  A single supply reduction may cause prices to spike, but inflation results when too much money chases too few goods and is ultimately evidence of a continuing monetary policy misstep.

The potential for economic stagnation and slow growth is a direct result of an increased presence of federal government involvement and regulation in the economy.  These types of policies slow the ability of the economy to adjust and lower growth rates.  However, the focus of this column is on the question of how an inflationary spiral can be expected even though monetary policy experts understand the threat is a result of current policy.  It is not a result of malfeasance or even an underestimation of the risks of inflation.  Rather the dilemma emerges from a constrained set of policy options in a highly political environment.

Right now the focus of monetary policy is the massive injection of reserves into the banking system and the use of monetary policy to accommodate the deficit spending at the federal level to maximize the economic stimulation.  The major complaint is that the funds injected into the banking system are sitting as excess reserves and not being lent out.  As long as the funds are in reserve they are not building inflationary pressure. 

Once the economy starts to recover the reserves would need to be rapidly drained from the system in order to prevent inflation.  The risks to the federal reserve are that being overly aggressive in fighting inflation when the economy starts to recover can force trigger a deeper recession.  Moving slowly allows a round of inflation. 

A similar dilemma faced policymakers in 2004.  The consensus is that they were too slow to change course and stimulated too long.  One challenge is learning to correctly read the economic tea leaves and recognize that the time is right. Even though the policymakers may have learned from that experience and be more accurate in anticipating the timing, the political constraints may not allow a different outcome this time.  The downturn we are currently experiencing is severe and will likely be the source of studies for years.  Against the current economic backdrop, policymakers have an incentive to err on the side of inflation rather than recession.  Inflation is a serious problem, but it is also an improvement over last year‘s economic problems.  That makes its recurrence more likely.

Darrell Parker, Ph.D., is Dean of the George Dean Johnson Jr., College of Business and Economics and Professor of Economics at USC Upstate.  The USC Upstate Johnson College is accredited by AACSB International (The Association to Advance Collegiate Schools of Business).  He can be reached at dparker@uscupstate.edu.