Stagflation is the condition in the economy when there is a rise in both inflation and unemployment. Typically, these two economic troubles are opposites. (See "Macroeconomics 101" from the March 18, 2008 posting). However, a bigger problem arises when both are apparent simultaneously. It is usually the result of a faltering financial market with an external shock that drives up prices. The relationship between inflation and unemployment is shown statistically on the Phillips Curve.
The illustration shows that there is a tendency when unemployment is low for inflation rates to be higher and vice-versa. The statistics above shows a period of stagflation in the 1970s and early 1980s. During that time period the curve is moved up and to the left. And just as it was during that time period, the major external shock to the economy was abnormally high fuel prices.
The goal of the Fed's loose-money policy is to decrease the unemployment rate however it does not seem likely that this will happen. The first sign is that commercial banks so far, do not seem to be willing to lower their interest rates to consumers. The reason is the fear that the rate of inflation will exceed interest rate. If the interest rate is lower than the inflation rate the real value of the money used to pay off the loan in the future will be worth less than the value of the money borrowed. As a result, banks will be losing money in the long-run if they lower their interest rates to match the Fed's rate cut. The formula used by banks to help determine the interest rate charged to borrowers is as follows:
Nominal Interest Rate = Real Interest Rate + Inflation Premium
Nominal Interest Rate = rate charged to borrowers
Real Interest Rate = base rate of borrowed money
Inflation Premium = anticipated rate of inflation
Hence, if the Real Interest Rate = 2.25%, and the anticipated rate of inflation = 4%, the nominal interest rate will be 6.25%. Since banks expect prices to continue to rise, it is not in their best interest to issue loans with lower interest rates even though the real interest rate may be cut.
For more, read "Banks Not Following Fed's Lead" from the Savannah Morning News.
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