Which way for the US economy now? Recently, the US Labor Department said that on a seasonally adjusted basis, the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.8 percent in July, following a 1.1 percent increase in June. The index for all items less food and energy increased 0.3 percent. So while inflation (ex food and energy) may be at manageable levels, the real, overall rate of inflation is probably closer to 10%. With oil now below $100 a barrel, inflation may ease. However, it is still well above the Federal Funds rate of 2.0 percent. So, what does this mean for the economy? Perhaps we will have 1970s-style stagflation, illustrated below in a chart of the Dow. Perhaps we will see a US version of Japan's banking crisis.
As is evident above, the Dow changed little over the years from 1970 to 1979. There have been many articles written on the topic of stagflation now, from the New York Times to The Guardian to the Economist. And today, basically, the US is experiencing slower economic growth, coupled with rising commodity prices and a tough housing market. Sounds like stagflation: slow growth, high prices.
For those who remember, the 70's were a difficult economic period. During the '73-'75 recession the Dow declined 28%; it is currently down about 23% from its high of 14,198. But how similar is today, really, to what happened in the 70's?
A large part of the inflation in the 70's was caused by an increase in the price of oil. In 1973, OPEC met in Tehran and doubled the price of oil from $5.50 to $11.00 per barrel. Part of the reason for this price hike was the Shah's desire for more foreign exchange in his bid to buy more military equipment. The other factor driving the increase was the fall of the dollar, in which oil was, and still is, denominated (dollar compared to the pound below, 1973-2007).
US inflation was running about 6% in the early 70's, but eventually exceeded 12% by 1975. During this time, the Federal Funds rate ranged from 3.75% to 6.25%, generally below the rate of inflation, an eerily similar scenario to that occurring today. Since the real interest rate = the nominal interest rate - inflation, real interest rates were negative for part of the early 70's when GDP growth was low, a primary cause of inflation.
Today's events are much the same. With US inflation measured at 3.5% last year and the federal funds rate at 2.0% (a rate not seen since the 1950's), real interest rates are negative. When you consider inflation rates with food and energy factored in, they are very negative. This has created an inflationary environment, and basically, the Fed is trapped in a slow growth/inflation box. If it lowers rates, inflation rises further. If it increases rates, the already slow economy suffers and the market heads south. With the federal funds rate at 2.0%, it there is little room to cut and how long can real raters stay negative? That means the government is subsidizing the economy with cheap money, a situation that cannot last forever. Even the Treasury and the US taxpayers have finite resources.
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