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Saturday, 21 June 2008

U.S. Slowdown,Price Increase Isn't Your Father's Stagflation

By Carlos Torres and Rich Miller

June 19 (Bloomberg) -- Stagflation just ain't what it used to be.

While economic growth has almost stalled, and surging oil prices have doubled the rate of inflation since the start of last year, structural changes in the economy since the 1970s mean the U.S. is unlikely to witness anything like the conditions that ravaged it then.

``It's a mini-stagflation,'' said Allen Sinai, chief economist at Decision Economics Inc. in New York.

Compared to the 1970s, the economy these days is more flexible, thanks to deregulation and advances in information technology. And it's less inflation-prone, because fewer workers are able to win big wage increases, and policy makers including Federal Reserve Chairman Ben S. Bernanke are more aware of the risks of letting prices spiral.

``We learned a lot of lessons in the 1970s,'' said Stephen Cecchetti, economics professor at the Brandeis University International Business School. ``I don't see the same sort of things happening again -- partly because of policy and partly because our economy is a little different.''

The seeds of the 1970s stagflation were sown the previous decade when government spending on social programs and the Vietnam War grew and credit became more readily available. A more rigid economy, including a system of fixed exchange rates, couldn't respond to the challenge of a jump in fuel prices.

Greater Competition

Today's economy is more flexible, fuel efficient and competitive. While the nation produced 10 times more last year than in 1973, energy use rose by only a third during that time, according to figures from Departments of Energy and Commerce.

Companies are also carrying smaller stockpiles, making it less likely they'd need to slash production when faced with an oil shock. The ratio of inventories to sales has been declining since 1982, when it reached a record 1.7 months, according to figures from Commerce. The ratio stood at 1.25 months in April.

``We live in a world where the automakers have their inventory on trucks on the way to the plants,'' said Cecchetti.

Airlines, one of the industries hardest hit by the jump in fuel costs, provide one example of how deregulation has spurred competition and helped hold down prices. Fares rose 1.8 percent last year, compared with a record 38 percent jump in 1980, during another episode of stagflation.

Chinese, European Pressure

``Companies have to price to markets,'' said Torsten Slok, an economist at Deutsche Bank AG in New York. ``Competition today is much more pronounced than in the 1970s. If a manufacturer doesn't price something sufficiently low, then someone from China or Europe will price it lower.''

Gains in worker efficiency and low labor costs also indicate prices won't skyrocket. Since 1996, productivity is up 2.5 percent per year on average. From 1970 to 1995, the gain averaged 1.7 percent.

The shift away from manufacturing and toward services has also contributed to a drop in labor-union membership that's reduced the ability of workers to get larger wage concessions. Union members accounted for 12 percent of the workforce in 2007, down from 20 percent in 1983 when the Labor Department started keeping records.

Average hourly earnings for non-managers and production workers were up 3.5 percent in the 12 months through the end of May, compared with a record gain of 9.5 percent in January 1981. The percentage of union workers with automatic cost-of-living adjustment clauses in their contracts fell from 61 percent in 1976 to 22 percent in 1995, when Labor stopped collecting data.

Volcker Legacy

Finally, Fed officials will be loath to surrender the low- inflation legacy bequeathed to them by former Chairman Paul Volcker, who raised the benchmark interest rate as high as 20 percent to bring prices under control. The cost was one of the worst recessions since World War II.

Sinai worries inflation expectations are already becoming ``unhinged'' and says much depends on how policy makers including those at the Fed react.

Households surveyed in June expected inflation of 3.4 percent over the next five years, according to the Reuters/University of Michigan survey published last week. While that would match the highest level in 13 years, it would still be well below the 9.7 percent reached in February 1980.

Under Chairman Arthur Burns, the central bank lowered interest rates in 1974 and 1975 to combat a slowdown, even as prices began to accelerate. Volcker and Alan Greenspan, who served as chairman from 1987 to 2006, spent most of the next two decades trying to get ahead of inflation.

Bernanke, Vice Chairman Donald Kohn and at least four Fed bank presidents warned over the past weeks that they must keep inflation expectations in check. Investors project the Fed will raise rates as soon as September, futures prices show.

``Monetary policy makers around the world certainly understand what they are doing much better than they did in the early 1970s,'' said Brandeis' Cecchetti. ``I'm sure that policy makers will not allow inflation to rise any more and they'll bring it back down.''

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