Recent evidence of higher than “expected” inflation and weaker than “expected” economic growth continue to support the likelihood of a “stagflation” scenario. For those unacquainted with US history prior to MTV, “stagflation,” an economic condition most associated with 1970’s, involves a period of stagnant growth and high inflation. If the latest economic trends continue, it may be time for all of us to dust off those polyester shirts and 8-track tape players.
Last week the government released higher than “expected” increases in both consumer and producer prices, and larger than “expected” increases in the trade and current account deficits. This week, the government released an unexpected 1.6% decline in May durable goods orders (the forecast had been for a 1.5% gain, and follows an even larger 2.6% decline in April), a larger than expected increase in unemployment claims, and an “unexpected” sharp downward revision to first quarter GDP growth (from a previously reported 4.4% to 3.9%). The GDP deflator was also “unexpectedly” revised upward to show a gain of 2.9% verses the 2.5% gain previously reported. The personal consumption expenditure index was also upwardly revised to 3.2% from the previously reported 3.0%. If these numbers accurately reflected the true rate of inflation, the first quarter GDP gains would have been anemic, even non-existent.
The fact that growth continues to decline, despite the lack of any Fed rate hikes and the continued expansion of the housing bubble (May’s home sales surged to a new record high), should be extremely troubling. So, too, should the fact that interest rates during the quarter were also artificially suppressed by record purchases of U.S. treasuries by foreign central banks, with the latter buying 150% of the former’s net quarterly issuance. Also disturbing should be the fact that first quarter growth was supported by the one time benefits of higher income tax refunds, and surging home equity extractions. If growth is decelerating now, considering all of the aforementioned temporary props, imagine what will happen when these props are removed.
Inflation, as measured by the CPI, is also likely to continue to increase, as the Fed’s “measured” rate hikes will certainly proceed at a rate slower than the rate at which inflation is likely to increase. With the Fed remaining behind the inflation curve, real interest rates will continue to fall even as nominal rates rise. This fact, and the continued expansion of the trade deficit, will exert increasing downward pressure on the U.S. dollar, which has recently resumed its decline against all the major currencies, this week falling to a 10-week low against the Japanese yen. The price of gold has also reversed its short-term decline, rising over $16 dollars per ounce during the last two weeks, closing above $400 for the first time in ten weeks.
Government numbers, flawed as they are, and recent market action in gold and the dollar, all point to the same conclusion: stagflation. U.S. equity and bond investors who continue to ignore these developments do so at their own financial peril. Pundits who continue drawing comparisons between today and 1994 should instead be looking at 1974. However, as the current period is evidenced by far greater monetary excess, and the United States is in a far weaker economic position, as evidence by its external liabilities, enormous fiscal imbalances, lack of domestic savings, diminished industrial capacity, and significant domestic leverage and sensitivity to rising interest rates, then was the case then, the “stag” is likely to be a lot more stagnant, and the “flation” a lot more inflationary, than was the case in the 1970’s.