The Economy: Why It's Not Déjà Vu

Wall Street is worried about '70s-style stagflation -- but the Fed is counting on productivity to keep the threat at bay

Suddenly a lot seems to be turning sour for the economy. Oil prices have soared: Despite a $3-per- barrel fall on Apr. 27, they've climbed nearly 20% in the past four months alone. Due to sharply higher prices at the gas pump, consumer confidence is cratering, falling to its lowest level in five months in April. Corporate execs also are turning more cautious as signs of weakness in the economy have many companies cutting back on their outlays. The Commerce Dept. reported on Apr. 27 that capital-goods orders, excluding aircraft and defense products, fell 4.7% in March, the biggest decline since September, 2002.

At the same time that the economy is cooling, inflation looks to be heating up. Led by higher energy prices, consumer prices jumped 0.6% in April, the biggest increase since October. Even after stripping out volatile energy and food costs, core consumer prices still rose 0.4%, their largest single-month gain in more than 2 1/2 years. Companies from heavy-duty machinery maker Caterpillar Inc. to hotelier Marriott International Inc. are able to jack up prices after years of being forced to hold the line.

To many on Wall Street, it looks a lot like a return to the stagflationary days of the mid-to-late 1970s. Those were hard times indeed, as the nation suffered a malady that economists of the time thought could never happen: stagnant growth coupled with roaring inflation. Then, as now, fast-rising oil prices sent shock waves throughout the economy. It was a bad period for stocks, too, as investors endured a multiyear bear market. No wonder Wall Street and others are furiously working the worry beads. "This is a treacherous kind of situation," says Allen Sinai, president of consultants Decision Economics Inc.


Yet there are some key differences between today's economy and the stagflation mess of the 1970s. For one, oil prices have risen far more gradually than in the 1970s, spreading out the impact over time. What's more, the runup is a result of soaring demand, not OPEC cutbacks. And the economy is a lot more energy-efficient: It takes 55% less oil and gas to produce the same amount of output today as it did in 1973. So while soaring energy prices have pushed up inflation, it is nowhere near the double-digit levels of the 1970s.

But the most important difference between then and now is productivity growth. Today's strong productivity helps protect the economy from the ravages of stagflation because it allows companies to make more with less. That boosts corporate profits, which gives businesses the power to spend and hire. And that, in turn, means the Federal Reserve can fight inflation by raising interest rates without snuffing out economic growth.

As a result, U.S. Federal Reserve Chairman Alan Greenspan doesn't face the same unpalatable choice that his predecessor, Paul A. Volcker, did in the early 1980s. Volcker used double-digit interest rates to break the back of inflation, sending the economy into its worst downturn since the Depression. Instead, Greenspan must decide between accepting somewhat slower growth or inflation that's a bit faster.

For now at least, Greenspan and other Fed officials seem prepared to accept a slightly weaker economy rather than risk an inflation breakout. They don't see the U.S. sinking into stagflation. Instead, they believe that the recent slowdown is little more than a temporary soft patch: Inflation, in the end, remains the more important threat.

Of course, all bets are off if productivity growth suddenly collapses. In that case, the economic outlook would turn bleaker and the trade-offs for Greenspan would get tougher as he counts down the days until his retirement early next year. Greenspan knows firsthand how hard it is to fight stagflation. He was chief White House economist when President Gerald R. Ford tried to attack inflationary psychology in 1974 with lapel buttons sporting the acronym WIN, for Whip Inflation Now. Ford later abandoned the buttons in favor of a big tax cut as the economy crumbled.

Back then, it was the accepted wisdom among economists that the quadrupling of oil prices engineered by the Organization of Petroleum Exporting Countries from 1971 to 1974 was the main force behind the inflationary surge of the 1970s. But many experts now argue that an unexpected slowdown in productivity growth -- and the Fed's mishandling of monetary policy in response -- were more to blame for the economy's pitiful performance in the mid-to-late 1970s. Faced with plunging productivity growth, Fed policymakers chose to ignore the inflationary consequences and instead kept pumping money into the economy. "They were too loose for too long," says New York University professor Thomas J. Sargent.

The betting is that the same thing won't happen this time. Over the past three years productivity has galloped ahead at a 4%-plus annual clip, so some easing of that impressive momentum is to be expected. In fact, economists surveyed by Blue Chip Economic Indicators forecast productivity growth will slow to 2.6% this year. But that shouldn't pose a significant inflationary risk to the economy, says economist Martin N. Baily of the Institute for International Economics think tank. With wages and other compensation costs currently rising at a roughly 4% annual rate, productivity growth of 2.6% would imply that unit labor costs were rising at about 1 1/2% per year. That's hardly a recipe for surging inflation -- and it remains a far cry from the double-digit wage increases and skyrocketing labor costs of the 1970s.

Behind the optimism about productivity growth is a belief in the long-run strength of capital spending. Although economists were disappointed by the latest capital-goods orders numbers, they remain confident that capital spending will stay strong this year. Many business leaders seem to agree. "There is still quite a bit of room here for the capital-goods side of the economy to grow," says Alexander M. Cutler, CEO of Eaton Corp. (ETN ), a diversified industrial manufacturer based in Cleveland. What accounts for that confidence? Many execs realize they have a long way to go before they fully exhaust the benefits of high technology in increasing efficiency and productivity. A December survey of corporate purchasing managers by the Institute for Supply Management found that 47% of manufacturing companies and 39% of nonmanufacturers felt they had reaped less than half the efficiency gains available from the use of high tech.


Thanks to the virtuous cycle of higher productivity leading to fatter profits, companies certainly have the wherewithal to spend more to increase efficiency even further. Corporate profits are booming, with the Standard & Poor's 500-stock index companies on course to report a hefty 12.4% increase in first-quarter operating profits (page 40), a far better performance than Wall Street had been expecting just a few months ago.

What's critical to the economy is long-term productivity growth. If productivity slows in response to the normal ebbs and flows of the economy, the situation is probably temporary. But if productivity decelerates for more fundamental reasons, such as a slowdown in technological innovation, it's a lot more worrisome. The trouble is that economists, including those at the Fed, might not know for a long while which situation they're dealing with.

There are already signs that the Fed is having trouble getting the productivity picture right. Former Fed official Edwin M. Truman notes that inflation came in faster and economic growth slower than Fed policymakers expected last year. That suggests they overestimated productivity growth. And with growth slowing and inflation heating up again, central bank officials may be making the same mistake this year.

In the end, the Fed can best help the economy by preventing inflation from running wild -- perhaps the key lesson to be learned from the disastrous experience of the '70s. It's one that Greenspan will undoubtedly have in mind as he tries to manage the economy in his last nine months as Fed chairman.

By Rich Miller, with Catherine Yang, in Washington, and Michael Arndt in Chicago

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