Stagflation?

Are we facing stagflation -- the dreaded combination of slow growth and high inflation? That's the question that comes to mind in reading this morning's report that first quarter economic growth fell below expectations and inflation jumped higher than it has in 16 years.

I have written about stagflation before but this morning's report is the most dramatic evidence yet that it might be here. GDP growth of 1.3% in the first quarter is well below that of previous quarters -- GDP grew 5.6% in Q1 2006 and 2.6% in the Q4 2006. But the kicker is that inflation -- as measured by the GDP price index -- grew at 4% in the first quarter, the highest rate in 16 years.

If stagflation persists, it could be bad for stocks. During the 1970s, stagflation kept stocks virtually unchanged for an entire decade. The problem is that if the Fed decides to raise interest rates to check inflation, the economy slows down. But if the Fed cuts rates to spur economic growth, prices spin out of control and the dollar drops in value -- following the report the dollar fell to an all-time low against the euro. This forces bond issuers to raise rates to attract foreign investors. And the higher interest rates cut economic growth.

With the U.S. economy so heavily dependent on debt -- both to consumers and to other governments like Japan and China -- the persistence of stagflation could paralyze the economy and the markets for a long time.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter.