Lava lamps, pet rocks, John Denver songs, blue eye shadow: The 1970s can conjure up some pretty frightening memories.

But these days, economists worry an even scarier relic of the disco era may be rearing its ugly head: stagflation, a not-so-groovy term used by economists to describe an economy plagued by recession, rampant inflation and high unemployment.

It’s the worst of all worlds – a toxic combination that vexed Federal Reserve policymakers more than 30 years ago and now threatens to put a squeeze on Fed Chief Ben Bernanke: Lower interest rates risk higher inflation, higher rates a long recession.

“The stagflation scenario is more than a likely possibility,” said Emanuel Balarie, chief executive of Jabez Capital Management, a California firm specializing in commodities and alternative investments.

Additional rate cuts will only be a temporary solution, he said.

“The recent rise in unemployment is just the tip of a much bigger economic iceberg,” he said. “We are heading toward a housing-led recession. On the inflation front, the record commodity prices clearly point to an economic scenario where inflation will be rampant.”

The word “stagflation” – a combination of the words “stagnant” and “inflation” – was coined by economists during the 1970s. Ultimately, former Fed Chief Paul Volcker performed shock therapy on the economy, jacking up short-term interest rates to 21 percent to squelch an inflation rate that peaked at 13.5 percent in 1981.

While no one is predicting the American consumer will have to endure a similar economic disaster, central bankers are increasingly worried the economy may be headed into deep trouble.

The U.S. stock market is off to its worst start since 2000 as the housing slump and turmoil in the credit markets continue to weigh on the economy. Home sales have fallen to the lowest in 12 years, the jobless rate jumped to a two-year high of 5 percent in December and government data last week showed manufacturing slowing in December to its weakest level since April 2003.

At the same time, prices are going up, thanks to the latest surge in oil prices, which last week touched $100 a barrel.

In November, the core rate of inflation increased 0.3 percent, bringing the year-over-year inflation rate to 2.3 percent – outside the Fed’s desired “comfort zone” of 1 percent to 2 percent, said Rich Yamarone, the chief economist at Argus Research.

But that number doesn’t tell the whole picture. Yamarone said many companies in consumer products, food and air travel have been announcing price increases due to a combination of higher costs and continuing high demand for their product.

Yum! Brands, for example, which owns KFC and Taco Bell, recently detailed significant increases in costs that included price hikes of 16 percent to 20 percent for chicken and 10 percent to 14 percent for cheese.

“Nothing influences consumer inflation expectations like the price of food, particularly milk,” Yamarone said. “Keep in mind that retail food prices have risen 4.8 percent over the last year, the largest increase in 17 years.”

Stuart Hoffman, chief economist at PNC Financial Services Group, described the economy as “a cat on a hot tin roof that has already used up eight of its nine lives.”

“One more fall from the hot roof and this economy cat is not likely to land on its feet once again,” he said.

That puts the Fed between the “proverbial rock and a hard place,” said Bob Doll, the vice chairman and director of BlackRock, an investment management firm. “If they lower rates too much, they may crease excess liquidity, which could lead to higher inflation. Not lowering rates enough, however, puts central bankers at risk of not being responsive to recessionary threats.”

Most economists expect the Fed to cut the short-term rate it controls to 4 percent at the Jan. 28-29 meeting. It would be the fourth consecutive quarter-point cut in less than six months.

Goldman Sachs this week said it expects the economy to drop into recession this year, forcing the Fed to cut its benchmark lending rate to 2.5 percent by the third quarter of 2008.

In a note to clients, Goldman said real Gross Domestic Product would contract 1 percent on an annualized basis in both the second and third quarters and the unemployment rate would rise to 6.5 percent in 2009 from the current 5 percent.

“We’re in a recession,” said New Jersey Gov. Jon Corzine, the former CEO of Goldman Sachs, in an interview.

The possibility of a stagflation threat to the economy is being hotly debated. Former Fed Chief Alan Greenspan first raised the possibility last month.

“I am most concerned about it (stagflation),” Greenspan said in a recent television interview. “Over the past 20 years, we have had a most remarkable period. Vast geopolitical shifts, including the end of the Cold War, have contributed to a remarkable period of disinflation. But that period is now coming to an end.”

Charles Plosser, the head of the Philadelphia Federal Reserve, also touched on the subject of stagflation this week.

“Although I am expecting slow economic growth for several quarters, we should not rely on slow growth to reduce inflation,” he warned in a speech. “Indeed, the 1970s should be a sufficient reminder that slow growth and falling inflation do not necessarily go hand in hand.”

JM END ALI

(Sam Ali is a staff writer for The Star-Ledger of Newark, N.J. She can be contacted at sali(at)starledger.com. Star-Ledger staff writer Josh Margolin contributed to this report.)

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