Stagflation: History Repeating Itself?

Earlier this week, the New York Times ran an article entitled: That 70s Look: Stagflation. The gist of it? The US is experiencing slower economic growth that requires a rate cut by the Fed. This is coupled with rising commodity prices. Sounds like, seems like stagflation. Similar stories have appeared in the Telegraph [UK], Guardian [UK] and Wall Street Journal. For those who remember, the 70s were a difficult economic period. As you can see below, in a chart of the Dow during the '73-'75 recession (indicated by the gray area), the index declined 28%. So what do I think will happen this time?

click to enlarge images

First, I think we are already in a recession. And I think housing will take years to unwind. My guess (and it's exactly that, a guess) is that the market will be level for a while and then drift lower slowly. I feel (this is a gut/intuitive impression) that there is no hurry to buy now if you are a long term investor, which I am. While I am a bull by nature, I sound like a bear these days, but a lack of realism never made anyone any money. And at the current interest rate levels, the Fed only has so many arrows left. I think its time to amass capital and wait for buying opportunities.

But how similar is today, really, to what happened in the 70s? The chart above is the annual rate of inflation during the 70s decade. A large part of the inflation then was caused by an increase in the price of oil. In 1973, OPEC met in Tehran and doubled the price of oil from $5.50 to $11.00 per barrel. Part of the reason for this price hike was the Shah's desire for more foreign exchange in his bid to buy more military equipment. The other factor driving the rate hike was the fall of the dollar (compared to the pound below, 1973-2007):

Since the real interest rate = the nominal interest rate - inflation, real interest rates were negative for part of the early 70s when GDP growth was low, causing inflation. For 2007, recent estimates are that inflation was 3.5% for the year, while economic growth slowed to 1.5%, see BBC story. Growth will be slowed, of course, by the housing and credit turmoil underway. High oil prices are also a factor today, just as they were in the 70s. If the Fed cuts rates further, it will be at or possibly below the current rate of inflation, creating negative real rates. If the housing and credit problems become an increasing drag on the economy, the high inflation-slow growth combination may be realized.

On the other side of the Atlantic, Europe has also rising consumer prices and falling output. The European Central Bank [ECB] now has to formulate monetary policy to deal with inflation and boost growth. In the UK paper Telegraph, Veronique Riches-Flores, Europe economist at Société Générale, said "investors were deluding themselves if they believed that Europe and the rest of the world could carry on growing briskly as the housing slump engulfed America."

This may, however, develop into a good time to buy industrials, banks and other unloved sectors if you are a long term investor. The one potential upside to a market slowdown is that some quality stocks get dragged down with the rest. You just have to be patient; it's a virtue, so they say.

Comments

[Danny Newton:]

Since 1982 there have been 14 months in which the moving one year average of the total vehicle miles traveled has gone negative. These events usually coincide with recessions but seven of these months have been recorded since July of 2006. Total US Vehicle Miles Traveled in 2007 dropped 3.9 % from the previous year. The states with the largest drops in vehicle miles traveled were in the Northeast except for Iowa. Only the state of North Dakota, in 2007, recorded a weak increase in the number of vehicle miles traveled over the previous year. Seven months in 2007 showed declines in Vehicle Miles Traveled in the US over the previous year. The initial minor drops in Vehicle Miles Traveled could be thought of as good since low priority trips would be the first casualties in reducing the consumption of transportation assets. These recent drops are breathtaking. Maine was 9.1% and Iowa was 9.9% under last year and last year was a general year of decline from the previous year.

Many will be quick to point out that the $3 dollar gasoline is causing the problem but the inflation adjusted cost of a gallon of retail gasoline in 1980 was $1.245. That same inflation adjusted price in 2007 would be $3.51 per gallon. From 1970 to 2004, the cost of food, shelter, apparel and medical care have all risen faster that the real cost of motor fuel according to the records in Table 3-9 in the extensive data base held by the Bureau of Transportation Statistics. Likewise, Table 3-14 in the same publication, proves that it is the fixed costs of automobile ownership like finance, taxes, insurance and registration that have risen at an annual average rate of 5.16 percent per year between 1975 and 2006 while the background average rate of inflation for the same time period was 4.61%.

2008 Mar 04 10:17 AM

[AlphaRomeo:]

US Stagflation may force net exporters such as China to grow their local consumption. This in turn will create a viable maket over the long term which will be an alternative to US market, but also a market for the US goods.

Econmic cycles are good for the long terms. The fixes or the preventative measures are worse sometimes.

2008 Mar 04 11:49 AM