Inflation/stagflation: An historical view

In Street Smart Report, market historian and seasonal timing expert Sy Harding takes an in-depth look at the reasoning behind the Fed’s inflation and stagflation concerns.

“Investors in their thirties and forties often don’t understand why the Federal Reserve sometimes becomes very worried about inflation.

“Their experience has been that, sure, the price of most everything rises over the long-term. But so what? They now pay $30,000 for automobiles their parents paid $10,000 for, and their grandparents bought for $2,000. Homes that sold for $50,000 in a previous generation now sell for $250,000.

“But their income has grown even faster, so their standard of living is significantly higher than it would have been fifty years ago. So what’s to worry about inflation?

“They are right - as long as everything stays in proportion. Therefore the main goal of the Fed is to maintain a steadily growing economy while keeping inflation under control, meaning having economic growth running at a faster pace than inflation.

“The Fed usually only becomes concerned about inflation when the economy starts to grow at a faster and stronger rate than normal, for instance as happened in 1999.

“A super strong economy creates increased demand for products, allowing producers to raise prices more quickly than normal, which in turn often increases workers’ demands for higher wages as their ‘cost of living’ goes up.

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“The Fed’s tool to cool off an ‘overheated’ economy, and thus prevent inflation from getting out of control, is to raise interest rates.

“However, once in a great while the control mechanism gets botched up, or unusual problems crop up, and the normal influence of economic growth on the rate of inflation disconnects, with the economy slowing but inflation spiraling out of control anyway.

“It’s a rare condition, dubbed ‘stagflation’, last seen in the 1970’s. No one who experienced it, consumers, the Fed, or investors, want to ever experience it again. And for good reason.

“In the 1970s, the economy slowed, in fact into recession. Yet inflation continued to rise. The Fed focused on cutting interest rates to stimulate the economy, and ignored the rising inflation. By the time the Fed reversed that policy, and began raising interest rates, it was too late.

“By 1979 inflation was running at almost 14% annually. And the belated rate hikes had become so aggressive that home mortgages rates were more than 12%. The ‘Prime Rate’, at which corporations with the best credit ratings are able to make business loans, hit 21%. Unemployment was approaching 10%.

“Meanwhile, the stock market suffered two bear markets, that of 1973-74 (the worst since the 1929 crash), and 1976-78.

‘Fast forward to 2008. The latest report was that the economy grew at a very anemic 0.6% in the fourth quarter of 2007, and most economists, including those at the Fed, project it will grow at only a 1.5% to 2% pace for 2008, with many believing we are already in a recession (negative growth).

“Yet inflation, as measured by the Consumer Price Index, rose 4.1% for all of 2007. But worse, the pace of inflation accelerated in the last three months of last year and even more so in January of this year.

“While there are many differences between now and the 1970s, there are also some spooky similarities. In the 1970s gold spiked to a new record high above $800 an ounce on the inflation worries. And in 2008 gold has spiked up to a new record high.

“In the 1970s there was a war in the Middle East, and the price of oil had risen a new record high. We currently have a war in the Middle East, and oil has reached a new record high. In the 1970’s the economy was slowing into recession, but inflation continued to rise.

“We currently have an economy slowing toward recession, but inflation continues to rise.  So the renewed concerns this week about the potential for stagflation are understandable, at least for the Fed, and anyone remembering the 1970’s.

“I don’t expect to see a repeat of the 1970s for the simple reason that the 1970s did occur. Many mistakes were made back then, but hopefully much was learned, particularly by the Fed.

“But investors do need to be aware of why the Fed has been worrying so much about the threat of inflation since it began cutting interest rates last year to re-stimulate the economy. Lower interest rates make it easier for inflation to get out of control.

“With recent reports showing that inflationary pressures have accelerated, the Fed is even further wedged between a rock and a hard place as it cuts interest rates to stimulate the slowing economy.

“If there are any signs this spring or summer that the stimulus package out of Washington has the economy beginning to recover, I think we can expect to see the Fed quickly reverse direction and begin to raise interest rates again to attack inflation. Otherwise, 1970s redux could be possible.”