Monday, April 28, 2008

Is this really 70's style stagflation?

April 28 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke may have to start talking and acting more like Paul Volcker if he wants to avoid being remembered as another Arthur Burns.

With oil and food prices surging, Volcker told the Economic Club of New York on April 9 that ``there are some resemblances between the present situation and the period in the early 1970s,'' when then-Fed Chairman Burns let an inflation psychology take hold. ``There was some fear of recession, the oil price went skyrocketing up, the dollar was very weak.''

It took Volcker's effort as Fed chief to push the overnight lending rate to 20 percent in 1980 and drive the economy into its deepest decline since the Depression to break the inflation he inherited. To avoid squandering the gains Volcker made, Bernanke may need to stop his all-out effort to prop up the weakening economy and start paying more attention to countering price pressures.

``You have to take the risk of the possibility of a small recession if you want to avoid ending up with a big one,'' says Allan Meltzer, a Fed historian and professor at Carnegie Mellon University in Pittsburgh.

As policy makers meet this week to decide on interest rates, Bernanke has one big thing going for him that Volcker, 80, didn't: Polls show Americans, for the most part, are still convinced the Fed will do what it takes to keep inflation down.

Self-Fulfilling Prophecy

That may become a self-fulfilling prophecy, as workers refrain from demanding big wage increases they don't think they'll get, and companies limit price increases for fear of losing sales.

Consumers expect inflation to average 3.2 percent during the next five to 10 years, according to a Reuters/University of Michigan survey this month. That compares with the 9.7 percent long-run inflation rate they expected in February 1980, seven months after Volcker took office.

``It's very different now than it was then,'' says Lyle Gramley, who served as a Fed governor under Volcker from 1980 to 1985 and is now Washington-based senior economic adviser for Stanford Group Co., a wealth-management firm. ``Americans have confidence in the Fed.''

Bernanke, 54, realizes he can't take tame inflation expectations for granted and needs to keep close tabs on price pressures. Traders in federal funds futures are betting such considerations will lead the central bank to take a break from cutting the overnight rate after reducing it a quarter percentage point this week.

No Cut at All?

``It's most likely that they'll cut by a quarter point,'' says David Jones, author of four books on the central bank and chief executive officer of DMJ Advisors LLC in Denver. ``But I wouldn't be shocked if they don't cut rates at all.''

Some economists say the Fed has already cut too deep, after slashing the benchmark rate by 3 percentage points since September to 2.25 percent. Meltzer says the rate should be at least 1 to 1.5 percentage points higher to keep inflation in check.

Michael Niemira, chief economist for the International Council of Shopping Centers in New York, says the Fed is setting the stage for a ``severe downturn'' in the economy in 2010 because its efforts to spur growth now will fan inflation next year.

Even some policy makers are concerned. Dallas Fed President Richard Fisher, who voted against the last two rate cuts, says persistently rising food and energy costs are starting to influence consumers' inflation expectations.

Fisher's Concern

``I'm concerned that we might be on a path of higher inflation than we would otherwise have had,'' Fisher said in a Fox Business Network interview aired April 22.

Since the start of the year, oil prices have risen 23 percent, while corn has climbed 27 percent and rice has jumped 76 percent.

Harvard University professor Jeffrey Frankel says the Fed's easing of monetary policy may be contributing to the run-up in commodity prices. The low rates make it cheaper for companies to finance and build inventories; they also encourage investors to shift money from low-yielding bonds into commodities.

``There is a speculative bubble building,'' says Frankel, who served as a White House economist under President Bill Clinton.

If so, it would be the third bubble the Fed has helped fuel since the mid 1990s: first in stocks, then in housing and now in commodities, says Tom Gallagher, senior managing director at International Strategy & Investment Group in Washington. Each bubble has had more of a direct impact on consumer prices than the previous one, he adds.

Undermining the Dollar

The Fed's rate cuts have also undermined the dollar, which has fallen 7 percent against the euro this year. That is making imports more expensive -- they rose almost 15 percent in the year ending March 31, the biggest increase since the government began keeping records in 1982 -- and pushing up inflation.

Edmund Phelps, winner of the 2006 Nobel Prize for economics and a professor at Columbia University, says the weak dollar makes it easier for U.S. companies to raise prices: ``It's going to induce firms to push up mark-ups. That's bad for inflation.''

It was in the 1970s too. Back then, the dollar lost value after President Richard M. Nixon ended the currency's convertibility to gold in 1971. Commodity prices took off, led by a quadrupling of oil prices from 1973 to 1975 as the Organization of Petroleum Exporting Countries cut output.

Fiscal Parallels

There are also parallels on the fiscal front, Frankel notes. In the 1970s, spending on domestic programs and the Vietnam War pushed up the budget deficit and raised the risk of inflation. These days, the war in Iraq and drug benefits for the elderly are having a similar effect.

The late Fed chairman Burns, who ran the central bank from 1970 to 1978, responded to inflationary pressures by raising interest rates to more than 10 percent. The U.S. suffered a 16- month recession that started in November 1973 and almost doubled unemployment to 9 percent.

Relief on the inflation front proved to be only temporary as Burns quickly backed off those rates. After falling from a 12.3 percent rate in December 1974 to 4.9 percent in 1976, inflation shot back up, reaching 13.3 percent by December 1979, Volcker's fifth month in office.

``The economy in the '70s had a tremendous inflationary bias; the recession slowed inflation but didn't stop it,'' says Wyatt Wells, a professor at Auburn University and author of a biography of Burns.

``The lesson of the '70s is that, more than anything else, the Fed has to keep inflation expectations anchored,'' DMJ Advisors' Jones says. ``Bernanke is about to get hit right between the eyes with that reality.''


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