Are You Ready for 'Stagflation-Lite'?

Is another big name from the 1970s attempting a comeback? Stagflation, the worst-of-both-worlds scenario in which weak growth is accompanied by robust inflation, may be on the radar again. It's enough to conjure memories of President Gerald Ford's ill-fated campaign to talk down prices through a "Whip Inflation Now" [WIN] campaign. The risk is evident in the latest economic numbers. Indeed, Marc Faber, the widely followed global investment adviser based in Asia believes that "we're already in stagflation: no real economic growth -- or recession -- amidst inflation" in his latest Gloom Boom & Doom Report.

Certainly, the economy is teetering on the edge of recession. Government statisticians reported on Jan. 30 that gross domestic product, dragged down by the declining home market, grew at an anemic 0.6% in the final three months of 2007. The 2.2% rate for all of 2007 was the worst performance in five years.

GDP Numbers Signal Trouble

With releases like the GDP report pointing to a weakening U.S. economy, the Federal Reserve is aggressively easing monetary policy to offset the gathering recessionary forces. The central bank cut its benchmark interest rate to 3% from 3.5% on Jan. 30. The sense of urgency for policymakers is clear: The Fed has slashed rates by a dramatic 1.25% in a mere eight days.

Yet inflation is also running hot. The GDP report has the prices of goods paid for by consumers during the fourth quarter increasing by 3.8%, up sharply from the 1.8% pace of the previous three months. The cost of living as measured by the more widely followed consumer price index rose by a steep 4.1% last year -- its highest rate in 17 years -- while in the last quarter of last year the CPI surged by 5.6%. No matter how it's measured, consumer inflation is well above the Fed's target range of 1% to 2%.

What if 4% is a CPI floor rather than a cost-of-living ceiling? It's possible, considering the Fed has eased so much that its benchmark interest rate is below the rate of inflation, a signal that inflation pressures could erupt later. Meanwhile, the weak dollar, combined with higher energy, food, and commodity prices, is exerting upward pressure on overall inflation. "We're in an environment of greater-than-average inflation risk," says James Paulsen, chief investment strategist at Wells Capital Management.

Fed "Can Keep Inflation Under Control"

To be sure, few prognosticators worry about a reprise of double-digit inflation rates of the 1970s. The international competition for goods and services is a force for lower prices. So is the current meltdown in the housing market.

Perhaps most important, considering the painful monetary lessons of the '70s, most economists believe the Fed wouldn't tolerate a repeat performance. "Philosophically, the Fed is much more attuned to the problem of inflation compared to the 1970s," says Mark Thoma, an economist at the University of Oregon. Adds James Hamilton, an economist at the University of California, San Diego: "The Fed is not an omnipotent institution, but it can keep inflation under control."

That could prove cold comfort. The risk for business, consumers, and investors is the emergence of a different kind of stagflation -- call it "stagflation-lite." It would be defined by higher-than-expected inflation rates [say, a 5.6% increase in the CPI] and lower-than-expected growth rates [like a 0.6% economic expansion].

Fickle Productivity Forecasts

A close look at the economy in the '70s gives pause. With the benefit of hindsight, it's clear that the Fed acted responsibly with the data available to it at the time, but the central bank's army of economists badly misread the tea leaves. Specifically, the Fed was aware that productivity had risen at a heady 2.7% average annual rate between 1948 and 1973. When the productivity growth rate plunged in the early 1970s, most economists expected it would bounce back. Instead, productivity fell to a less than 1% annual rate between 1973 and 1979, and to 0.32% from 1979 to 1982. [The figures are from Edward Fulton's Trends in American Economic Growth, 1929-1982.]

And that was the big problem for the Fed. Monetary policy was too expansive for an economy with deteriorating productive capacity, calculates Athanasios Orphanides, an economist at the Federal Reserve who has delved into central bank policy during that troublesome era. [The research paper is "Activist Stabilization Policy and Inflation: The Taylor Rule in the 1970s," February, 2000.]

America's productivity growth rate is similarly suspect today. Productivity growth has averaged a healthy 2.6% over the past decade. Yet since midyear 2004, it has come in at a much lower, 1.6% pace. Some economists expect productivity will take another haircut as consumers' borrowing zeal of recent years cools off [BusinessWeek, 1/23/08]. Still, it could be a long time before the trend in productivity is clear, raising the risk that the Fed overestimates the economy's speed limit and, like the 1970s, ends up with a too-loose monetary policy that results in higher rates of inflation.

Investors Hedge Against Inflation

It's striking how investors are snapping up assets that boomed during the inflationary '70s, pushing them to high levels -- and even record prices. For instance, while the dollar is trading at low levels in the international currency markets, gold, a classic hedge against inflation, is near its record price, now at $919 an ounce. Prices for key commodities such as oil, food, and platinum, are at nosebleed levels. The stocks of companies in industries with a history of "pricing power" such as cereal makers and electric utilities are attracting investor interest. Indeed, almost all the traditional safe havens against the ravages of spiraling inflation are doing well. And the last time real estate values and stock market prices declined sharply together was 1974 -- a period of both recession and inflation.

That said, it's strange that bond prices are up and bond yields down despite the recent high inflation figures. One interpretation: Investors aren't worried about inflation. However, it could be that lower yields reflect a global flight to financial security rather than a lack of concern over higher prices.

The Fed, Wall Street, and Washington are primarily concerned about recession right now. The Fed's press release after the Jan. 30 Federal Open Market Committee meeting gives a strong impression that more cuts are coming: "[D]ownside risks to growth remain. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act in a timely manner as needed to address those risks."

Yet it might not be long before inflation starts climbing a wall of worry. When that happens, expect to hear a lot more about the return of stagflation.

credited by: BusinessWeek.com