WHATEVER may go wrong with the economy, ``stagflation'' is an unlikely scenario. The winter's news stories about jumps in wholesale and consumer prices misread the inflation outlook. All the same, they added impetus to credit market tightening and an interest-rate ``spike'' followed. Although the Fed seems to have backed away from that policy, 1990's economy has already been hurt. Most of the traditional leading indicators confirm that a recession is on the way. To get a clear perspective on these matters, a trio of tested ideas proves indispensable. First, persistent historical evidence is a more reliable guide than the most hallowed economic theories. Second, markets are smart. Financial markets are fully tuned in to the important factors that govern the economy and that give early warning of its shifting gears. Third, financial prices have impressive predictive power. The trick is to decode and interpret the price quotes to be found daily in the financial pages.
``Stagflation'' is a snappy buzzword for describing a situation in which stagnation and inflation coincide - once thought to be a highly anomalous, if not impossible, situation.
But stagflation is not a single malady. Its two components need to be addressed separately, because their causes are largely independent.
Take, for example, the ``stag-'' part. Historical evidence shows the credit market to be an excellent barometer of ups and downs in the national income.
Short-term interest rates are central to the diagnosis. Since January, they have been signaling a recession for 1990 - on present indications a mild one. The last time they did something like that was the late spring of 1981, correctly calling the severe recession of 1982. Their track record is little known, but strong. Since the postwar period began, every recession that has occurred could have been anticipated by a careful interpretation of interest-rate movements.
The ``-flation'' part is a more difficult target for forecasting, but it can be approached in a similar way.
The first point about predicting inflation is to recognize what physicists call ``inertia.'' This is where the old supertanker analogy comes in: It takes a long time to turn things around. Because of the way the government measures prices, inertia is even more characteristic of changes in the cost of living. Once inflation gets going, it is apt to chug along smartly for a year or two. When it slows down, it tends to stay lower for a year or two. As a result, an excellent first-pass estimate of next year's inflation rate is the rate for this year. The challenge lies in predicting accelerations and decelerations in inflation.
History suggests that the markets for commodities and foreign exchange are good barometers of ups and downs in the inflation rate. In particular, the average value of the dollar in terms of foreign exchange has a good record as a summary indicator of inflation pressure. It is a widely available statistic.
Between 1985 and 1986, the average value of the dollar plunged 24 percent. Between 1986 and 1987, it dropped 15 percent. From 1987 to 1988, it declined 5 percent. And in 1989, the dollar performed better than it had the year before. But overall this is a consistent story of decelerating pressure on the cost of living.
Most commodity markets tell a similar story. Prices have been decelerating or downright falling - except for oil. The world oil price surged this year, and energy prices were a central feature of this past winter's nasty surprises concerning wholesale and consumer price indexes. A wave of inflation warnings hit the news media in the wake of this transitory shock to the indexes.
But let's not be misled by special factors relating to one sector of the commodity markets, however important. Over the long haul, inflation is a monetary process and we should look for a consensus in the commodity markets to reveal its future course.
The oil price surge seems to be over for now, and there is no particular reason to expect present monetary trends to be reversed soon. Over the next year or two, inflation should be on the wane.
Even though the Fed has probably backed off, the results of its tilt with the inflation windmill will be with us for a while. Now 1990 is likely to be an unpleasant economic experience. A real ``stag-'' has been brought to life by ``-flation'' fears that are proving to be groundless.