We're back to the 1970s. The Washington Post reports that the Fed's Beige Book suggests that growth is stagnant and prices are rising. That's an economic condition known as stagflation -- slow growth and high prices. That's bad news for policymakers and investors.
I first posted about Stagflation back in May 2006. What is striking to me is that the price of oil was $69 a barrel back then and it's almost double that now. Back then I noted that stagflation "prevailed in the US during the 1970s. For example, in 1979, US core inflation, excluding oil and food, rose at a 9.4% annual rate, GDP grew at roughly 3%, and unemployment averaged 6%. Furthermore, this condition was bad for stocks which rose an anemic 0.37% annual average during the decade." I also wrote about stagflation here and here.
Here are three key findings from the Beige Book:
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Weak retail spending - The Post reported that consumer spending was weak, despite the economic stimulus checks from the government that went out starting in May. There was some demand for electronics, and discount stores got a temporary boost. But discretionary spending froze on housing-related items and vacations.
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Declining real estate - The Post reported a weak national housing market. Also, a new real estate negative -- commercial real estate -- which had boosted economic growth, is also slowing down.
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Rising prices - The Post reported "skyrocketing prices for fuel and other commodities." It also noted that since their costs of higher raw materials had risen, companies were planning to boost prices to maintain margins. Today, McDonald's (NYSE: MCD) announced that it would join those companies by raising prices on its dollar menu.
So what should be done? To answer that, it might help to look at history. What got the U.S. out of stagflation in the 1980s was a massive increase in interest rates. Paul Volker raised the Fed Funds rate to about 19%. This was great for people invested in money market funds. It also caused a nasty recession and -- most importantly -- squeezed the life out of inflationary expectations. The result was very low stock prices relative to asset values. Junk bonds financed corporate takeovers that shifted those dormant asset values into the hands of investors. And the Dow began an 18 year rise from 800 to over 10,000.
The current administration has left a different problem for the next president than the one that Ronald Reagan faced in the early 1980s. In my view, the key to solving our current woes is a multi-pronged strategy to strengthen the dollar, which has lost 72% of its value since January 2001. That means raising interest rates to attack inflation, balancing the Federal budget, and cutting our national debt.
At the moment, however, Washington appears determined to add $800 billion to that debt to $10.6 trillion -- a perilous 75% of GDP -- so it can bail out Wall Street and its $12 trillion mortgage-backed securities holdings. So it will await the next president to kill stagflation and revive the economy.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in McDonald's securities.
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