The Fed has voted -– for stagflation

By Jim Jubak

The Federal Reserve seems determined to bring back the 1970s -- and that won't be any Golden Oldies party for investors.

The Fed has just voted for stagflation, a dreadful mix of slow-to-no growth and high inflation that made a good part of the 1970s such a bad time for investors. According to Ibbotson Associates, the S&P 500 ($INX) showed a compounded annual return of just 3.2% from 1973 to 1979. Long-term government bonds didn't do a whole lot better with a 3.5% compounded annual return for the same period.

Mind you, those were the nominal rates of return for the period -- that's before inflation. Figure in inflation and investors lost money during these years. (For more on stagflation see my July 4, 2006, column, "Stagflation: A new peril for stocks.")

At the Aug. 8 meeting of its Federal Open Market Committee, the Fed decided not to raise key interest rates. That put an end to a string of 17 consecutive increases in short-term interest rates that had taken the central bank's benchmark from 1% in June 2004 to 5.25% now.

A wing and a prayer

Oddly enough, Fed officials chose to end their attempt to lower inflation by raising interest rates even as they publicly acknowledged that inflation had picked up speed. "Readings on core inflation (Translation: Overall inflation minus changes in the volatile prices of food and energy) have been elevated in recent months," the Fed said in its press release. "However, inflation pressures seem likely to moderate over time."

"Seem likely to moderate." I'd call that flying the economy on a wing and a prayer. If the Federal Reserve is wrong, the pause in raising rates will give inflation more time to pick up momentum in the economy and to build the kind of entrenched inflationary expectations among consumers and businesses that the Fed has been trying so hard to head off.

Why did the Fed punt on inflation on Aug. 8? Because the central bank under its new chairman, Ben Bernanke, continues to believe, as it did under its previous chairman, Alan Greenspan, that it can fine tune its way to a soft landing. A tweak to interest rates here to lower inflation, a pause there to stop the economy from slowing too much, and the Federal Reserve will be able to bring the economy in for a perfect three-point landing: Inflation will slow next year to 2% to 2.25% and the economy will grow at 3% to 3.5%.

There's already a problem with these hopes on both counts.

Inflation: Raising the bar

First, there's a growing body of evidence that inflation may be revving up instead of slowing down. The big worry on inflation is that consumers and businesses will both come to expect future inflation and those inflationary expectations will create something called the wage-price spiral. Prices go up, so workers ask for wage increases, which lead businesses to raise prices and workers to ask for another wage increase, quickly spiraling out of control.

One of the most hopeful signs that inflation was under control until recently had been the slow growth in wages. Increases in wages had struggled to keep up with inflation, but that may be changing. In data for the second quarter of 2006 released in early August, unit labor costs -- the wages and benefits paid per unit of output -- climbed at a very strong 4.2% annual rate.

That's a huge reversal: Unit labor costs actually fell for much of the 2002-2004 period as productivity increased faster than wage and benefit costs. That decline offset some of the higher costs of commodities, since raw materials make up only about 10% of the total cost of production.

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