Is The Fed Driving Us into an Age of Sagflation?

Summary
The U.S. economy has likely entered a period of "Sagflation," defined as sagging economic activity combined with greater price instability. The dwindling ability of the government to stimulate the economy, both monetarily and fiscally, likely causes a period of economic rationalization. The increasing efforts of the Federal Reserve to "print money" to fend-off deflation likely produces wider price swings as money sloshes around the economy unevenly. The weaker economic growth coupled with greater price uncertainty is a potentially lethal combination for stock valuations, or at least increases volatility. In this environment I expect indexes to swing wildly and generally decline over long periods of time. Investors following a passive U.S. index-related strategy may not see growth in their portfolios for extended periods, unless they time their entry and exit perfectly. U.S. stock picking will be harder and greater weighting should be placed on U.S. exporters and international investments.

The Situation
On June 26 I posted: "If the economy slips backward I would expect to see more focus on non-traditional monetary policies to stimulate inflation." This month the Federal Reserve, after an extended internal debate, decided to reinvest maturing mortgage investments back into Treasuries. In
the Wall Street Journal yesterday is an editorial by Alan Blinder, the former vice chairman of the Federal Reserve Board, in which he states, "the bad news is that the Fed has already spent its most powerful ammunition." He then goes on to discuss the four traditional options left for the Fed, which are purchasing more assets, effectively trying to talk up investment spending, cutting the interest rates on reserves to zero or even negative, and easing up restrictions on healthy banks to enable lending. I would expect to see the Fed try a mix of all these options by the end of the year if the economy continues to slow. If the slowdown deepens then I expect to Fed to move to more non-traditional actions in 2011 that may include buying other asset classes and actively devaluing the dollar.

So will these monetary actions pull us out of the ditch? Or, should an investor remain face-down while an economic tornado rips across the country? If investors pick-up their heads, where are the best opportunities. To answer these questions let's re-visit the underlying trends in the economy.

"What man is, only history tells." - George Mosse

A String of Powerful One-time Stimulants since 1981
From May 1981 to September 1992 the Federal Funds rate dropped an astonishing 17%, from  20% (yes, 20!) to 3%, where it stayed until 1994. This amounts to a massive stimulus that likely set an elevated "normal" expected rate of growth in the economy, in my view. In my opinion, it enabled companies to continually invest in more marginal projects and still create an economic profit. In April 1991 the Federal Funds rate dropped below 6% and has since only briefly re-touched that level in 1995 and 2000. As I argued in a June 26 post, by dropping the federal funds rates and talking down the yield curve, thus lowering the cost of capital for businesses, the government can create economic profit for companies. This action helps healthy companies recover that were temporarily impacted by an economic slowdown. As a side effect, the Fed action also enables weak companies to remain in business. For proof of this point, read "Weak Firms Pile on Debt and Trouble" in today's Wall Street Journal. If monetary policy is over-used to stimulate growth then I believe it creates longer-term structural problems.

In the 1990's the inflation rate appeared to become more loosely tied to the growth in money, a breakdown in monetarism economic theory. Alan Greenspan explained the phenomenon as a result of a virtuous cycle of productivity and investment. The 1990's was the decade of "creative destruction" of management structures as companies adopted more networked technology and eventually the internet, which enabled lowered cost structures (and thus helping to offset price inflation pressure). The improvements in productivity were extended beyond 2000 by technology advancements and outsourcing to lower labor cost regions, like India for services and China for manufacturing. In 1997 the Fed began expanding the money supply in anticipation of Y2K and continued growing it on average by over 6% each year through to today, with few signs of inflation.

By highlighting these historical trends I hope to show that: (1) economic profit growth was artificially accelerated for almost 30 years, (2) weaker companies have remained in business, thus increasing price competition amongst all companies, and (3) business has enjoyed an unusual period of improving efficiency that has helped offset inflation pressures. These trends were finite in nature, and thus the question becomes: What next?

The Age of 'Sagflaton' in the U.S.?
Sagflation has been used to describe several different economic situations. For my purposes, I define sagflation as a general economic decline combined with price instability, both within industries and the economy.

The current slowdown in economic activity is a reversal of 20-plus years of government-enabled over-investment, in my view, which had produced above-sustainable growth. As explained in the previous section, the period of super-charged growth was driven by aggressive fiscal and monetary policies, as well as an unusually powerful period of business-driving technology advancement. The 5-10 year economic outlook now includes the unsavory mix of: (1) interest rates moving away from low single-digits, (2) higher capital gains and income taxes, (3) rising labor costs as U.S. immigration is tightened and wages increase in China and India, (4) potentially higher commodity prices as more countries compete for resources, (5) greater U.S. government austerity (or ballooning deficits), and (6) increased regulatory oversight.

Either cash flow needs to improve or invested capital needs to shrink in order to allow overall ROIC to recover above an increasing cost of capital, and therefore create economic profit. The biggest concern is a virtuous cycle in which capital rationalizations cause declining business activity, which results in lower cash flow generated from the existing capital base, which in turn causes additional capital rationalization.

Real world check: The NFIB Research Foundation's Small Business Economic Trends for August 2010 highlights that a majority of small businesses have, for almost 2 years, dropped prices in the past 3 months. This is extraordinary for both the length and percentage of companies actually cutting prices for their goods or services. For the 35 years prior to 2009 the survey almost always showed a majority of companies increasing prices and only a few times showed even parity between the number of small businesses raising and lowering prices. My interpretation of these figures is that there are too many resources (invested capital) chasing too few customers, or put differently, there is over-capacity since these businesses do not have pricing power. These data points suggest a period of deflation until the capital base is rationalized to a level in-balance with lower demand trends, higher tax rates, and rising cost of capital.

On November 21, 2002 then Federal Reserve Governor Ben Bernanke stated in a speech on deflation, "By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation." 1

From Mr. Bernanke's statement I believe he will aggressively utilize mechanisms to increase the money supply to offset the natural tendency of the over-invested economy to deflate, or sag. The problem with this strategy, especially in the short-term, is what Keynesian economist refer to as "pushing on a string." In other words, it is hard to increase inflation with monetary policy. Instead you may just put a lot of loose pricing dynamics into the economy without a general increase in prices. I argue that we have seen this manifested in dotcoms, housing, and now treasuries. I would even argue on-going double digit price increases in healthcare was another manifestation that the government had to address directly.

If demand trends sync-up with the invested capital base of the economy (for example - U.S. exports increase as the U.S. dollar declines), enabling greater pricing power for companies, we could see spikes in prices if too much slack is in place. The Fed would likely argue that it could tighten policies to restrain inflation, but this is my point: An overly active and aggressive monetary policy that produces large swings in the money supply likely produces widening swings in prices, in specific industries, asset classes, and in the economy as a whole. This will likely, and has already, create significant fundamental challenges for businesses.


Thus I see an outlook of flat to declining economic growth with increasingly volatile prices, or as I term it - Sagflation. Buckle up!

Note: The Small Business Economic Trends is a copyright of the NFIB Research Foundation and can be found here: http://www.nfib.com/research-foundation.