No Reruns of the Seventies Here

07/10/2008 12:00 am EST


Howard Gold

Founder & President, GoldenEgg Investing

As gasoline prices soar and Americans face sticker shock at the checkout counter, inflation is on everyone’s mind.

But how bad is it, really? Not as bad as many think—and a lot, lot worse elsewhere.

Sure, many people are feeling pain, especially those who have modest incomes and need their cars to get around.

But inflation in the US simply isn’t near what it was in the bad old 1970s, when it approached 10% at its peak—and it’s not likely to get there. The real rerun of “That ‘70s Show” is playing in the once-high-flying economies of Asia and other emerging markets.

This won’t make me popular with the America-Is-in-Decline-Like-Rome crowd. But despite all the doom talk going around the media echo chamber, this is one scare that’s way overblown.

Here’s why. Although “headline” inflation has risen to over 4%, core inflation remains remarkably steady, at around 2%.  Core inflation, of course, measures the overall inflation rate without including food and energy.

Now that seems “counterintuitive,” to use economists’ jargon—or against common sense. Don’t food and energy prices hit people especially hard? So, shouldn’t any realistic measurement of inflation include them?

Well, yes. But there are two problems with that. Food and energy prices rise and fall, sometimes dramatically. We don’t think that they will now, but they have in the past—many times. Remember when oil was $10 a barrel? That was just nine years ago. I’m sure it won’t fall that low again, but barring an attack on Iran by Israel, I’m also pretty sure that in a few months crude prices will be much lower than they are now.

Second, the Fed simply can’t do much about food and energy prices, so it can’t target them as a policy goal, explains Robert Brusca, chief economist for Fact and Opinion Economics in New York.

Brusca, who observed the inflation of the 1970s and thinks we’re nowhere near that now, says that combating those likely transient price rises would require the Fed to raise interest rates much, much higher than they are now. That would plunge the country into a deep recession or worse.

Brusca also points out that by two commonly accepted measures, money supply growth has been pretty subdued. Milton Friedman famously pointed out, “Inflation is always and everywhere a monetary phenomenon.”

In fact, because of the financial crisis, credit has dried up. That’s not inflationary. “Banks aren’t lending,” he observes. These days, banks are taking reserves for all kinds of loans—auto, credit card, commercial real estate. Has anyone tried to get a mortgage lately? Then you’ll know what I mean.

Paradoxically, rising oil prices may ultimately lower inflation. By taking a bigger chunk out of consumers’ wallets, higher gasoline prices reduce disposable income, just like a tax increase. So people will have less to spend on other things.

That’s why many companies are eating the higher costs and accepting lower profits. They know that people whose homes and stock portfolios are worth less and who are paying $80 to fill up their tanks are in no mood to fork over the extra $10 for that “must-have” wallet from Coach.

But the biggest difference between now and the 1970s may be the most obvious. Back then, powerful industrial unions won big wage hikes and cost-of-living adjustments from major US manufacturers like General Motors in contracts that locked in their gains for years. The companies promptly passed those increases on to consumers, resulting in a wage-price spiral.

When was the last time you heard of a big strike? Maybe when the Hollywood writers hit the bricks. Fact is, unions represent only 12% of the workforce, down from 30% in the 1970s, and the negotiations we’re reading about today focus on how big the cuts—not the increases—will be.

When factories are shuttered and employers routinely shift jobs overseas, the chances of a similar wage-price spiral are virtually nil. “In the US, workers haven’t had any pricing power,” says Brusca. 

For all these reasons, I can’t see how US inflation will get much higher in the coming months. In fact, when global demand for crude slows and oil prices finally crack, I expect even headline inflation to ease.

That’s what the bond market is telling us. It has quietly rallied over the last few weeks, as ten-year Treasurys are well under 4%. “Inflation is historically the notorious kryptonite of fixed-income investments, yet bonds are nonetheless outperforming equities,” writes Richard Bernstein, Merrill Lynch’s chief investment strategist, in Thursday’s Financial Times.

So, relax—but not if you live in the emerging markets, particularly in Asia. There, inflation is truly eye-popping: 8% in China and India, 12% in Russia, 14% in Turkey, and perhaps over 20% in Vietnam, Pakistan, and Argentina.

Not only do food and energy take a bigger bite out of people’s budgets there (twice as much, on average, as in developed countries), but wages are skyrocketing—some 17.7% a year in China in the third quarter of 2007, according to the Bank for International Settlements. India and Russia also are reporting double-digit annual wage increases.

Energy-inefficient economies and quickly rising wages are a dangerous brew. Throw in central banks that are goosing the money supply to promote growth and, well, it’s déjà vu all over again.

“The broad money supply has grown by an average of 20% over the past year in emerging economies, almost three times the pace in the developed world,” the Economist recently reported.

“Russia’s money supply has swelled by fully 42%.” Ouch. The official US figures are somewhere over 6%.
And those central banks, wary of derailing the growth machine, have been cautious about raising interest rates, leaving them way behind the inflationary curve. That’s why many emerging market economies have deeply negative real interest rates (rates minus inflation)—an untenable situation in the long run.

No wonder the Economist concluded: “The biggest risk from rising inflation lies in emerging economies, not in the developed world.”

So, go ahead, you nostalgia hounds, dust off those old Donna Summer cassettes and load “Saturday Night Fever” into your DVD player. But this time set the subtitles for Mandarin, Russian, or Hindi.

“Stayin’ Alive” means the same thing in all languages.

Howard R. Gold is executive editor of The opinions expressed here are his own and are not necessarily the views of InterShow or
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