We've believed for quite some time that the current period bears much resemblance, economically speaking, to the 1970s. Consider the following trends, all of which took place in the 1970s and are doing so again today:
- The stock market remains range-bound over the long term as inflation eats away at real stock valuations.
- Real bond yields remain very low and sometimes go negative.
- Gold, commodities, and other inflation-hedge investments are in a multi-year bull market.
- The Federal Reserve is continually behind the curve on fighting inflation.
- On weekends I wear plaid Sansabelt slacks and a mint-green polyester jacket with lapels so enormous that I am occasionally borne aloft during strong winds.
We can add another similarity to the list: the term "stagflation" is now showing up all over the news again.
"Stagflation," a portmanteau that combines "stagnation" and "inflation," refers to a persistant rise in prices alongside weak economic growth. The term was invented in response to the idea, widespread back in the 1970s and still today, that slowing economic growth invariably leads to decreasing price inflation.
In truth, the type of aggressive easing that we've recently seen from the Fed tends to lead to inflation whether there is an economic slowdown or not. Back in the 1970s, the resultant inflation showed up primarily in consumer goods and services, as measured by the Consumer Price Index. The difference is that here in the 2000s, the inflation -- the decline in the purchasing power of the currency -- has made its way less into goods prices and more into financial asset prices. But it is inflation nonetheless.
The following chart approximates the real Fed funds rate by subtracting the nominal funds rate from the trailing rate of year-over-year rate CPI inflation. Even by this measure, which excludes any purchasing power loss that is not captured by the CPI, one can see that Fed policy of protracted negative real rates during the 2000s has looked a lot more like that of the inflationary 1970s than the disinflationary 1980s and 1990s.
We can expect more of the same. It's not clear on the chart, which is only current through January 2008, but as of this writing the target Fed funds rate of 3.0% is 1.3% below the most recent year-over-year increase in CPI inflation. And as recently as three days ago, despite rising inflation and serious dollar weakness, Fed chairman Ben Bernanke once again assured Congress that the Fed "will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks."
The 1970s are back, at least as far as monetary policy goes. We suspect that we haven't heard the last of the term "stagflation."
The Federal Open Market Committee
discusses the finer points of monetary policy.
