Stagflation, Anyone?

Remember the 1970s? It was known as the “Me Decade” and for bad music (disco). Among the other, more significant developments was “stagflation”: a period of stagnant economic growth, soaring inflation and, as a consequence, high unemployment.

Stagflation has edged back into the conversation about the economy and markets this month. First, the World Bank lowered its projected global growth rate for 2014 to 2.8 percent from its previous 3.2 percent. Then the International Monetary Fund lowered its forecast for U.S. growth from 2.8 percent to 2 percent.

This week, the final revision for the U.S. economy’s performance in the first quarter of 2014 came in at a dismal -2.9 percent, even worse than the pessimistic consensus.

Based on the general tenor of economic reports over the last three months, growth likely rebounded to an annual rate approaching 3 percent in the current quarter and could do so again in the July-September period.

After that, it’s anybody’s guess, particularly with the Federal Reserve gradually tapering its monthly purchases of Treasury and mortgage securities. We have yet to see 3 percent annual growth in the current economic recovery, which is now entering its sixth year.

In addition, job growth remains sluggish, with the decline in the official unemployment rate to 6.3 percent attributable in large part to the many people who have left the work force.

Meanwhile, prices of most commodities are up sharply in 2014. Energy, agriculture and precious metals led the way, with only industrial metals faltering. Prices for food, health care, heating/AC and more have climbed meaningfully. No doubt, many of you have noticed shrinking portions of various supermarket products, just like in the inflationary ’70s.

Last week, we heard that the consumer price index (CPI) is now up 2.1 percent over the last 12 months through Ma! y, and 2 percent excluding food and energy.

This week brought the latest numbers for the Federal Reserve’s favorite inflation gauge, the core personal consumption expenditure (PCE). Core PCE gives more weight to health care and less to housing. Over the past 12 months, the PCE has climbed 1.8 percent, and the core PCE, again excluding food and energy, is up 1.5 percent.

Either way, it’s widely acknowledged that the official government numbers understate inflation, partly because of changes made in the calculation methods over the years.

In other words, inflation indeed is dormant if you don’t eat, don’t drive, don’t send kids to college, don’t need healthcare and don’t breathe. 

What Lies Ahead?

Over the past 20 years, the CPI has averaged 2.4 percent, far from the double-digit levels of the late 1970s. So the current level of inflation is near the long-term trend.

Better economic growth seems likely in the near term, in the U.S. if not elsewhere. Our job market, as defined by qualified workers, may be tightening. The movement to raise the minimum wage is gathering momentum.

By historically normal measures, economic growth of 2.5 percent a year (we hope); 2 percent inflation, which is the Fed’s target rate; and a 6.3 percent unemployment rate would call for a more normal monetary policy.

In theory, that should lead the Fed to start raising its benchmark short-term interest rate as soon as the first quarter of 2015, earlier than most people currently expect. That rate has remained in the zero-0.25 percent range since December 2008.

We see three counter arguments. First, the Fed likely has to risk acting too late before hiking its short-term rate. Reason: If economic growth falters, the need for easier money could increase again, leading the Fed to reverse course.

Second, inflation is considered primarily a monetary phenomenon by many. In other words, it comes from “too much” mo! ney chasi! ng goods and services. Currently, all too much money is doing nothing: Money velocity is low despite the Fed’s aggressively easy policies.

Third, aging societies tend to grow more slowly than when their populations were younger. To a lesser extent, the US is now experiencing what has been happening in Europe and Japan for some time.

Bond investors, arguably the most inflation-sensitive, aren’t worried yet. Fixed-income yields are depressed in much of the world, including the 10-year U.S. Treasury issue down nearly 2.5 percent.