Are You Ready for 'Stagflation-Lite'?

Even as the Fed unleashes rate cuts, the economy may be in for weak growth coupled with inflation, though not as severe as the 1970s

by Chris Farrell

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.)