Murmurs of stagflation hint at challenge for Fed

For his part, Fed Chairman Alan Greenspan categorically dismissed concerns about stagflation in response to a question Thursday from a member of the Senate Budget Committee. He and other Fed officials have expressed far more concern about long-term structural problems stemming from the twin U.S. budget and trade deficits.

“It is worth noting that these sorts of imbalances are not new,” Fed Gov. Donald Kohn said in a speech Friday. “But the magnitude of these imbalances is increasingly moving into unfamiliar territory.”

He said the Fed intends to continue raising interest rates, in part to dampen the “upward momentum in housing prices” and encourage Americans to increase their personal savings.

And Kohn warned of potentially sudden changes in asset prices, much like the tech-stock bubble that collapsed in 2000. “Although the odds seem favorable for an orderly adjustment, the current imbalances are large and — importantly for gauging risks — unusual from a historical perspective,” Kohn said.

His comments echoed a warning recently issued by former Fed Chairman Paul Volcker, who warned that record trade deficits mean “we are skating on increasingly thin ice.”

The near-term threat from stagflation seems remote compared with what could happen if, for example, China were to substantially reduce its purchase of dollar-denominated assets, causing a sharp decline in the dollar and corresponding increase in interest rates.

“I think the U.S. economy is really kind of fragile,” said Paul Kasriel, director of economic research at Northern Trust Co. “If interest rates were to spike up like they did in the ‘70s, we would see the U.S. economy crumble.”

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