That 70's Feeling
Ben Bernanke may be facing a nasty relic of the disco era. It's called stagflation
Give me a one-handed economist," President Truman once supposedly demanded of his White House staff. "All my economists say, 'On the one hand ... on the other.'" Good thing Truman isn't sitting in the Oval Office these days. He might be dealing with an awfully exasperating fellow-the dreaded three-handed economist.
On the one hand, the economy looks as if it might be headed into deep trouble, even a recession. The bubblicious housing market, a critical support for the economy in recent years, is clearly popping. Home sales have fallen to their lowest levels since 2004, while the number of homes sitting on the market is at a 10-year high. And luxury home builder Toll Brothers-whose stock price has been halved during the past year-last week reported a 19 percent drop in profits from a year earlier.
Things don't look much livelier for the auto industry. GM and Ford both have recently announced production cuts, and sales are down more than 9 percent from last year. Then there is the economy-dampening impact of 17 straight interest-rate increases by the Federal Reserve before the central bank finally paused earlier this month. Indeed, the nation's gross domestic product grew by just 2.5 percent in the second quarter, down sharply from 5.6 percent in the first quarter. "The economy is in worse shape than after the tech bust in 2000," says Nouriel Roubini, a New York University economics professor who also runs his own consulting firm. He thinks there's a 70 percent chance that the economy is headed toward a recession.
But then there's the other hand: Prices keep going up. During the first seven months of 2006, the consumer price index rose at a 4.8 percent seasonally adjusted annual rate. That compares with an increase of 3.4 percent for all of 2005. Rising oil prices were a big reason for that, of course. Yet even excluding food and energy, inflation still rose 3.1 percent, up from a 2.2 percent rise for all of 2005.
Core problems. Many economists saw good news, though, in the inflation stats for July. Core CPI came in at 0.2 percent after rising 0.3 percent in each of the prior four months. But, as economist Dean Baker of the Center for Economic and Policy Research points out, if you factor out the seemingly anomalous 1.2 percent drop in apparel prices in July, core inflation would have been 0.3 percent again.
This isn't how the economy is supposed to work. Weaker demand should translate into prices rising more slowly, if at all. But that's not been happening. So here's where the "third hand" comes in: The U.S. economy seems to be experiencing a bout of stagflation. It's a rare, worst-of-both-worlds situation where economic growth and employment stagnate yet inflation rises. The clunky term was coined by economists in the 1970s to describe the terrible mix of sluggish growth, soaring unemployment, and high inflation that then plagued the American economy. In 1974, for instance, the U.S. economy shrunk 0.5 percent and unemployment rose to 7.2 percent, even though prices skyrocketed 11 percent. Oil shocks, loose Federal Reserve monetary policy, and out-of-control government spending have all been blamed for the stagflation. The economic mess culminated in America's worst economic downturn since the Great Depression.
Does any of this sound familiar? Today, not only does the economy show slowing growth and rising inflation, but once again it is being hit by dramatically rising energy prices. Job growth during this point in the economic cycle is already less than half that of previous periods. Add in the unwelcome return of guns-and-butter deficit spending by Uncle Sam, and it may seem as if all that is missing for a total '70s flashback is some new ABBA tunes.
So are we in the middle of Stagflation II? Well, "Son of Stagflation" is the preferred term of Ethan Harris, chief U.S. economist at Lehman Brothers. "We are in an economy that is slowing to a little bit below trend growth, and inflation is creeping up," he says. Harris thinks all this is enough of a problem that the Fed should raise interest rates twice more this year. Still, Harris adds, "this is nothing like the stagflation of the 1970s."
He and his clients had better hope not. The stagflation of the 1970s was a catastrophe for financial assets. Adjusted for inflation, stocks lost 13 percent during the decade, while government bonds fell 16 percent. But lately stock prices have been rising, a sign of investor optimism. Yet investors also seem to be hinting at a stagflation call. The yield on 10-year treasury bonds has fallen from 5.23 percent on June 24 to around 4.8 percent last week. That may mean bond investors expect weaker growth. Yet the spread between those bonds and 10-year treasury inflation-protected securities (TIPS) has widened, a sign that investors expect rising inflation. Weaker growth plus rising inflation expectations-that smells a lot like stagflation.
Soft landing? But there's stagflation and then there's stagflation. Richard Berner, chief U.S. economist at Morgan Stanley, thinks Wall Street's worrywarts need to dial it down. "We have just gotten too used to low inflation and solid growth," he says. "Now we're in a period where inflation is higher and growth has slowed." And that slower growth should help bring down inflation, in a soft landing for the economy. While Berner thinks the housing market is headed for a hard tumble, he also expects a booming global economy to cushion the blow.
Fed Chairman Ben Bernanke is another soft-landing guy. When the Fed abstained from raising rates at its August meeting, the move was perceived as a bet by Bernanke that inflation pressures would be relieved by lower energy prices and a slowing economy. No inflation, no stagflation-and no need for more rate hikes. Of course, gambling on lower oil prices has been a sucker's bet in recent years. And those who believe that global oil production has peaked would argue that it will ever be thus. Yet Carl Weinberg of High Frequency Economics thinks the bout of higher prices has begun softening demand, which, in turn, should bring prices down. Indeed, the Organization of Petroleum Exporting Countries, or OPEC, recently cut its forecasts of world oil demand for the rest of this year to 1.3 million barrels per day, 80,000 fewer than it expected a month ago. Weinberg expects a "very sharpbreak in oil prices at some point soon, perhaps after the hurricane season in North America."
But on the other hand ...
This story appears in the September 5, 2006 print edition of U.S. News & World Report.