December 2007

What about Stagflation?

By Brad C. Stewart, Vice President/Chief Investment Officer

Let me start off by saying that I know my prediction that there would not be a Fed rate cut at the FOMC meeting held on October 31st was wrong. But remember I said that I “for one” felt they would hold off. By the time of the actual meeting, I believe I was the only person predicting that the Fed would hold off. Actually, there was one other person who felt that a reduction wasn’t called for, and that was the president of the Kansas City Federal Reserve, Thomas Hoenig. He was the lone dissenter and voted to leave rates unchanged. Chairman Bernanke summed up the FOMC’s reasoning when he said the risk that the housing downturn will slow the economy seemed greater than the risk of higher inflation. A week after the reduction, Federal Reserve Governor Mishkin stated, that the cut was aimed at reducing the economic risks, and policy makers can take back the move, should it prove “unnecessary.”

At the end of last month’s FYI, I mentioned that the topic of the November FYI could have been “Stagflation.” I wasn’t the only person who recognized the similarities in the 1970’s description of the economy and some of the present circumstances. In Chairman Bernanke’s recent testimony before the Joint Economic Committee of Congress, Representative Hinchey, D (N.Y.) questioned the Chairman about the return of “stagflation.” Bernanke told Congressman Hinchey that he didn’t anticipate anything near the 1970’s economic situation. The next day, it was reported that the Chairman warned that “stagflation” could be a real danger.

What is the definition of this 1970’s phenomenon and why am I even talking about it? The definition, according to Investopedia, is “a condition of slow economic growth and relatively high unemployment-a time of stagnation-accompanied by a rise in prices, or inflation.” This condition existed in the 1970’s, and it has been suggested several times since then that it could be returning. The number one condition that was present then, and is certainly present now, is the rising price of oil. Currently, oil has been approaching $100 per barrel, having recently traded at $98 per barrel.

However, the United States is enjoying an unemployment rate and an inflation rate that is nothing remotely similar to the rates in the 1970’s. We have a Federal Reserve that is acutely aware of the dangers of allowing inflation to get ahead of the curve. So again, why are we even talking about ‘stagflation” or maybe I should call it “Stagflation-lite? ”

I think the answer is two fold. First, history has a tendency to repeat itself, but it doesn’t mean that the exact conditions will be repeated; only the end result. Second, based on our current conditions, the fear of stagflation is not something that is going to happen now. It is certainly something that we should be concerned about in the future, especially with the price of oil and the housing debacle.

Keep in mind that the Federal Reserve is moving overnight interest rate targets, knowing that the full impact of the move will not be felt for six to nine months. Wall Street, on the other hand, is looking for a solution for their problems today. A reduction is more of a psychological booster.

And finally, I, along with everyone here at Mid-Atlantic Corporate, hope that each and every one of you has a very Happy Holiday Season and a Prosperous New Year!