Stagflation: Even if the Economy Stagnates, Your Investments Don't Have to do the Same

By Martin Hutchinson
Contributing Editor

For months experts have been whispering about the dreaded "R" word - recession.

But a week ago, an even more insidious term was uttered - and by none other than U.S. Federal Reserve Chairman Ben S. Bernanke.

That new term was the "S" word - stagflation.

Speaking to the Senate Finance Committee recently, Bernanke said the United States isn't "anywhere near" the dangerous stagflation of the 1970s.

Well, I hate to be contradictory, Ben, but we've pretty well got stagflation now. And in a few months time, that nasty combination of high unemployment and rising prices may seem a fond memory, since stagnation trumps recession any day of the week - and twice on Sundays.

The challenge is this: How do we - as investors - make a buck out of this gloom?

Before we get to that, let me regale you with the "Story of Stagflation." Although it's a historical tale, as you read it, you'll get the eerie feeling that you've heard this same story somewhere else - in a more-recent setting, and with a cast of characters whose names are much more familiar.

The Seeds of Stagflation

Stagflation didn't happen under the so-called "Gold Standard." During normal periods, as part of the natural ebb-and-flow of the economy, you'd periodically get huge recessions, but very little inflation. During wartime, you got inflation, but that rise in prices was accompanied by economic expansion.

It was something of a shock to everyone when, in 1969-70, the United States was staggered by an economic downturn - at a time when inflation was galloping along at 5% to 6%.

Prior to that, stagflation - the one-two punch of a stagnant economy combined with rising prices - was pretty much viewed as one of those economic theories that could never appear in real life.

Looking back now, the cause of the first stagflation was pretty clear. President Lyndon Johnson wanted to keep running the Vietnam War even as he expanded U.S. social programs under his "Great Society" initiative.

The only way to wage war overseas even as you boosted spending to solve problems at home, of course, was to run a big budget deficit. [If this scenario seems somehow familiar to you, keep reading].

In order to prevent his war from becoming even more unpopular than it already was, he ordered Fed Chairman William McChesney Martin Jr. [in office from 1951-1970] to keep rates low by printing money. As early as 1963, Martin knew there might be a problem, and even told Federal Open Market Committee (FOMC) policymakers that "for the first time in a long while, the committee might find itself faced with serious problems with prices and with an incipient expansion at an unsustainable rate."

President Johnson's ability to bully the gentlemanly Martin was unprecedented. By the end of his term, Martin told FOMC members that "the line between political and economic decisions has been almost obliterated."

Martin, a good monetarist, retired in January 1970 knowing he had failed. The seeds of stagflation were already sown. But U.S. consumers weren't aware of the pain that was to come: The consumer price index (CPI) rose by a moderate 4.1% in 1968 and 5.4% in 1969 [equivalent to about 3.3% and 4.6% in today's inflation stats, which our helpful government "adjusted" back in 1996].

There are two lessons to be learned from this period. First, stagflation was already embedded in the system by 1969-70. Second, monetary policy was over-expansionary for years - as far back as 1963, in fact - before inflation appeared in a virulent form.

Stagflation Strikes

When LBJ shelved his 1968 re-election bid, he bequeathed a "booby-trapped" economy to his successor, Richard Nixon. Inflation and a recession were both already inevitable.

Nixon, no economic genius himself, battled back, instituting wage and price controls in 1971. For a year, his solutions worked: In 1972, prices rose only 3.2%.

But with an expansionist monetary policy still in place, once price controls were lifted, inflation exploded, hitting 6.2% in 1973 and 11% in 1974. Late in 1974, after Nixon's resignation, we got the ultimate stagflation indicator, the "Whip Inflation Now," or W.I.N button - withdrawn after only 6 weeks in favor of an emergency program to fight the very severe recession and budget deficit that had appeared.

Contrary to popular belief, mild recession was not at all incompatible with rising inflation; only deep recession provided something of a solution.

President Gerald Ford's policies in 1975-76 were sensible, so inflation receded, public spending declined as a share of gross domestic product, and the budget deficit declined.

Enter President Jimmy Carter in 1977 and his Fed chairman, G. William Miller, in 1978. Neither saw inflation fighting as a major priority, so inflation, which had retreated to 5.8% in 1976, spiked to 7.6% in 1978, 11.3% in 1979 and 13.5% in 1980.

Miller was essentially fired by the bond market in July 1979, and was replaced by the great Paul Volcker, who in October 1979 pushed interest rates up sharply and began a personal dual with the inflationary desperado. The years of 1979-82 were years of recession and extremely tight money, with the Federal Funds Rate peaking at 20% in December 1980, so inflation dropped to 10.3% in 1981, 6.2% in 1982 and 3.2% in 1983.

At the cost of a deep recession that lasted three years, with a tiny recovery in the middle, Fed chief Volcker had found the solution to stagflation.

The rest is history and very nice history too - we have been living for the last 25 years on the fruits of Volcker's monetary policy.

A Pinch of This and a Dash of That

So what caused the stagflation of the 1970s? There were a number of factors, but if you want to create stagflation, there are three catalysts that seem to increase the odds:

  • Let the Money Supply Fly: The Fed's Martin was worried about an over-expansionary monetary policy as far back as 1963, and in the late 1960s he essentially lost control of it to Johnson. Note, however, that there was a very long lead time of five to six years before the excessive money-supply growth produced serious inflation
  • Borrow and Spend: By and large, an expanding public sector makes the economy stagnate, but you can disguise that stagnation for a number of years through the use of budget deficits. The cost, of course, is a building inflationary pressure.
  • Go Long and Get Strong: A long economic expansion accompanied by strong unions was a key stagflation catalyst. The economic expansion of the 1960s was the longest until the 1990s; by the end of the decade, strongly unionized industries such as automobiles had become irresponsible in the settlements they made with unions to avert strikes. In the short run, this produced wealthier blue-collar workers; in the long run, it exported the once-dominant U.S. auto sector to Japan and East Asia.

Déjà vu All Over Again?

If we use our economic TiVo to fast forward to the U.S. malaise of the present day, we see that all three of these factors are present, albeit in a slightly different form. For instance:

  • Big Payouts Return: There are today no strong unions, but we've all read repeatedly about how top management and the deal-making heavyweights at the major investment banks have been extracting hefty pay raises in the form of massive year-end bonuses. Since the financial sector is to the U.S. economy today what the union-dominated manufacturing sector was to the American economy back in the 60s and 70s, today's big bonuses are equal to the rich union contracts of yesteryear: Both served to push up U.S. costs and prices in a general way.
  • Budget Deficits are Back: The budget deficit declined in the three years prior to 2007, but this year's shortfall is projected to be as high as it was in the depths of the last recession. It's a disgraceful performance: Just like LBJ, President George W. Bush has been trying to finance welfare expansion and a war simultaneously, although in Bush's case tax cuts worsened the deficit problem even more.
  • The Printing Presses are Rolling: The money-supply growth under the Bush/Bernanke tandem mirrors closely the major misstep of the Johnson/Martin era. Under Johnson and Martin, the money supply grew by an 8.4% rate from 1963 to 1968, and then accelerated to an annual growth rate of 9.8% through to 1973. Under the Bush/Bernanke team, it grew at a 9.2% annual clip from 1996 to 2001, before slowing to a 7.1% pace from 2001 to 2006 - still faster than the rate of growth of the overall economy. The Fed ceased reporting money-supply growth in early 2006, though it's a virtual lock that the growth rate would have accelerated.

The mystery therefore is not why we may be getting stagflation now; it's why we didn't get it earlier, particularly in the 1999-2000 period when money supply, the stock market and economic growth were roaring ahead. After all, if the 1990s had followed the pattern of the 1960s, consumer price inflation would have been 5% and rising by 2000.

Almost certainly, the solution to this mystery lies in the Internet, and global communications generally. After 1995, it became much cheaper and more efficient to outsource production to such low-wage countries as China and India. The price decreases were passed on to consumers, and that created a bit of a "delayed reaction."

Since last year, the benign effect of global outsourcing has begun to wear off. In both China and India, inflation is advancing at near-double-digit rates, and both the yuan and rupee have advanced against the greenback. That, in turn, has caused the costs of Indian services and Chinese manufactured goods to rise substantially in dollar terms, thus removing their benign effect in holding down inflation.

We can now expect inflation to really take hold, and we're already starting to see indications that's happening. The Consumer Price Index was up 4.3% in the year to January while the Producer Price Index, reflecting prices earlier in the production process, was up 7.4% in the same period.

Companies are watching profits plummet and soon will start cutting their work forces to cut their costs. The economy will soon start to stagnate.

The bottom line: It seems likely that we are indeed in a period of stagflation, that as in 1969-79 politicians and monetary authorities will remain in denial on the subject for several years [hopefully not for an entire decade this time around] and that the process of exiting stagflation will be as painful as it was under the Volcker regime at the Fed.

Unfortunately, with the housing market on the fritz and interest rates low, the central bank may actually be more reluctant than usual to start raising rates, since that will inflict even more pain on struggling homeowners.

Staying Ahead of Stagflation

Stagflation's here. And it's going to remain for some time.

That's the bad news.

The good news is that there are always plenty of ways to profit.

One way is by shorting long-term Treasury bonds. At yields below 4%, the 10-year Treasury bond reflects both loose money and an inflation forecast of 2.5% or below. The Rydex Juno Inverse Gov Long Bond Strategy C Fund (RYJCX) is designed to move inversely to Treasury bonds. Until now, it has been a terrible investment as T-bond yields have trended steadily downward and prices upward. It may now be ready to come into its own.

Another way to make money in a period of stagflation is through the gold market. While gold has risen a very long way since 2000, from $270 per ounce to around $980, it is still likely to rise further as investors worldwide come to realize that inflation is back. After all, gold's 1980 peak of $875 per ounce is equivalent in inflation-adjusted terms to more than $2,200 today. There are no huge new sources of gold coming on stream and one gold-producing country, South Africa, is beset with labor problems and now has a thoroughly unreliable electric power system.

So long as monetary policy worldwide remains lax, and Bernanke believes stagflation is not a threat, gold will do well. The StreetTracks Gold Trust (GLD) exchange-traded fund (ETF) is about the most efficient way of getting a pure gold play.

Finally, you can put some of your money in a market which is on a different cycle, has not had significant inflation, and where stagflation is thus not a threat. Japan had its bubble in the late 1980s, and since 2003 has been recovering from the subsequent recession, while inflation has remained around zero or even negative. Interest rates in Japan are still too low - at 0.50% in the short term they don't provide an adequate return for savers.

Nevertheless, Japanese companies, particularly those not dependent on exports, should continue to thrive even as the rest of the world is suffering stagflation. The Japanese market has performed abysmally recently, down 25% in the last year, but that may be about to change. You can consider either a Japanese technological leader such as Omron Corp. (PINK:OMRNY), the world leader in fuzzy logic control systems, or a domestically oriented ETF like the SPDR Russell/Nomura fund (JSC), invested in small company Japanese shares with little exposure to export markets.

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