The Federal Reserve seems determined to bring back the 1970s -- and that won't be any golden-oldies party for investors.
The Fed has just voted for stagflation, a dreadful mix of slow to no growth and high inflation that made a good part of the 1970s such a bad time for investors. According to Ibbotson Associates, the
showed a compounded annual return of just 3.2% from 1973 to 1979. Long-term government bonds didn't do a whole lot better, with a 3.5% compounded annual return for the same period.
Mind you, those were the nominal rates of return for the period -- that's before inflation. Figure in inflation, and investors lost money during these years.
At the Aug. 8 meeting of its Federal Open Market Committee, the Fed decided not to raise key interest rates. That put an end to a string of 17 consecutive increases in short-term interest rates that had taken the central bank's benchmark from 1% in June 2004 to 5.25% now.
A Wing and a Prayer
Oddly enough, Fed officials chose to end their attempt to lower inflation by raising interest rates even as they publicly acknowledged that inflation had picked up speed. "Readings on core inflation
translation: overall inflation minus changes in the volatile prices of food and energy have been elevated in recent months," the Fed said in its press release. "However, inflation pressures seem likely to moderate over time."
"Seem likely to moderate." I'd call that flying the economy on a wing and a prayer. If the Federal Reserve is wrong, the pause in raising rates will give inflation more time to pick up momentum in the economy and to build the kind of entrenched inflationary expectations among consumers and businesses that the Fed has been trying so hard to head off.
Why did the Fed punt on inflation on Aug. 8? Because the central bank under its new chairman, Ben Bernanke, continues to believe, as it did under its previous chairman, Alan Greenspan, that it can fine-tune its way to a soft landing. A tweak to interest rates here to lower inflation, a pause there to stop the economy from slowing too much, and the Federal Reserve will be able to bring the economy in for a perfect three-point landing: Inflation will slow next year to 2% to 2.25%, and the economy will grow at 3% to 3.5%.
There's already a problem with these hopes on both counts.
Inflation: Raising the Bar
First, there's a growing body of evidence that inflation may be revving up instead of slowing down. The big worry on inflation is that consumers and businesses will both come to expect future inflation and that those inflationary expectations will create something called the wage-price spiral. Prices go up, so workers ask for wage increases, which lead businesses to raise prices and workers to ask for another wage increase, quickly spiraling out of control.
One of the most hopeful signs that inflation was under control until recently had been the slow growth in wages. Increases in wages had struggled to keep up with inflation, but that may be changing. In data for the second quarter of 2006 released in early August, unit labor costs -- the wages and benefits paid per unit of output -- climbed at a very strong 4.2% annual rate.
That's a huge reversal: Unit labor costs actually fell for much of the 2002-2004 period, as productivity increased faster than wage and benefit costs. That decline offset some of the higher costs of commodities, since raw materials make up only about 10% of the total cost of production.
Labor costs typically lag the economy. So the big increases in wage and benefit costs -- up at a 5.4% rate in the second quarter -- are just now starting to reflect the low rate of unemployment overall and the absolute scarcity of workers at any price in some important pockets in the economy, such as the oil industry. Predictions now call for 5% to 6% jumps in wages and benefits, with productivity increasing at something like its long-term trend rate of 3%. That would lead to unit labor cost increases of 2% to 3% at an annual rate.
It's hard to see how inflation is going to increase at just 2% to 2.25% if labor costs are climbing by 2% to 3% and energy and raw-materials costs are also continuing their rise.
And That's Not All
But there's a second problem with the Fed's inflation goals as well. Predicting that core inflation will drop to 2% to 2.25% for 2007, as the Federal Reserve has, sounds reassuring, since core inflation, as measured by the consumer price index, ran at 2.9% last month. However, that's the highest annual rate in 11 years, so the projected drop to 2.25% would be significant.
That 2% to 2.25% range is still above the target of 1% to 2% inflation that the Fed has repeatedly described as its comfort zone, however. It sure sounds like the best the Fed is expecting on inflation for next year is above the target the bank hoped to achieve with the interest rate increases that began in 2004.
Slowing to Too Slow
Of course, the Federal Reserve wouldn't have ended its string of interest rate increases in August if it weren't worried about the pace of economic growth. The economy as a whole grew by an annual rate of just 2.5% in the second quarter of 2006. That's a huge drop from the 5.6% growth in the first quarter of 2006 (which was pushed upward by post-Katrina rebuilding in hurricane-stricken areas) and significantly lower than the 3.3% growth rate in the second quarter of 2005.
The details may be worse than the overall picture. The long-awaited slowdown in consumer spending may have arrived: Consumer spending climbed by just 2.5% in the second quarter after gaining 4.8% in the first quarter of 2006. Economists have long expected that rising interest rates, which cut back on consumers' ability to raise cash by refinancing their ever more valuable homes, would damp increases in consumer spending.
But the longed-for increase in business investment, which is supposed to balance out the decline in consumer spending, also looked weak in the second quarter as business investment gained just 2.7% after a huge 13.7% increase in the first quarter of 2005.
Easing the Pressure
Putting higher interest rates on hiatus for August also takes the pressure off two big, troubled and very interest-rate-sensitive sectors of the economy: housing and cars.
Sales of existing homes dropped by 1.3% from May to June as higher interest rates on mortgages slowed buying. Existing-home sales have shown a monthly gain only once over the past 10 months and are now down 10% from the record high of June 2005. The supply of existing homes on the market now equals 6.8 months of sales, up from just 5.2 months of inventory as recently as February 2006.
But that's actually good news. So far the oft-predicted collapse of home sales and housing prices has failed to materialize. The median and average prices for an existing home sold in June climbed about 1% from June 2005. That's, again, a huge decline from the 10% annual median gain in the price of a sale recorded as recently as February 2006. But it's still a long way from a collapse in prices. The Federal Reserve would like to keep it that way.
The Federal Reserve also has the U.S. auto industry to worry about. Rising gas prices have left Detroit with a serious mismatch between the models they have to sell and the kinds of cars that consumers currently favor.
It hasn't helped that the big cars, SUVs and light trucks that provide the bulk of Detroit's profits are exactly those models facing slower demand. New and updated designs have helped sales of some models, but ultimately Detroit has found itself reliant on cash givebacks and low-interest financing offers to move its inventory. Every hike in the interest rate makes it more expensive for Detroit to keep financing terms attractive enough to keep sales from plunging further. And despite its troubles, the U.S. auto industry -- from carmakers to parts suppliers to dealers -- still makes up a huge hunk of the U.S. economy. A slowdown in Detroit sends out very long-lived ripples.
A Tough Call
So the Federal Reserve found itself between a rock and a hard place. Keep raising rates to fight inflation and further weaken an already slowing economy. Or stop raising rates and risk creating a tough-to-eradicate inflationary psychology.
And the Fed plopped down on the side of growth with the hope that inflation was headed in the right direction.
I hope Ben Bernanke and company are right. I have no desire to live through -- let alone invest through -- the kind of tough recession that the Federal Reserve would have to create in order to wring inflation out of the economy if it became convinced that inflationary psychology had taken hold with consumers and businesses. The eventual "necessary" recession would wind up being even deeper if the Federal Reserve persists with its belief in its ability to tweak the economy and decides to respond to lower-than-expected economic growth with interest rate cuts in 2007.
But I'm not optimistic. I can find only one instance in all of its history when the Federal Reserve managed to engineer the kind of soft landing -- 1994-95 under Greenspan -- that the current Federal Reserve is hoping for. In every other case, the Fed has had to force the economy into a recession to get inflation under control.
I wish us all better luck this time. But I'm not counting on it.
Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;
to send him an email.