Stagflation and Analysis

This week’s blog is my forecast for the economy for the next 3 to 5 years and my supporting analysis. My forecast is for stagflation which is high unemployment rate with inflation. Remember the Carter administration (1976 to 1980) which is known for stagflation and the misery index (employment rate + inflation rate)? We could be headed for the same economic environment that existed in the Carter years.

Interesting URLs:

Misery index: http://www.miseryindex.us

Money supply definition (M1, M2 and M3): http://en.wikipedia.org/wiki/Money_supply

US Debt Clock: http://www.usdebtclock.org

Analysis of the major causes of inflation:

1. One of the major causes of inflation occurs when the money supply grows faster than the potential output of the economy or real GDP. Over the last two years the M1 money supply has increased by 25.5% and M2 has increased by 11.5%. For the same time period the real GDP has decreased by .5%. This will promote higher inflation rates over the next 3 to 5 years. At the same time, the Feds may decide to keep interest rates low for political reasons. Examples of political reasons why the Feds would keep interest rates low are: to keep mortgage rates down (to help get us out of the housing crisis), to promote higher employment, keep the federal government debt payment level lower, etc. This will bring about more inflation as it leads to unsustainable levels of growth and inflation because cheap money is available. With lower interest rates on treasury bonds the Feds will be the lender of last resort and will need to buy the bonds. The only way they can buy more bonds is by printing more money (just like the last two years) and increasing inflation. The Feds or Congress may also determine the only way to pay off the national debt (over $12.7 Trillion and counting) is to make money cheaper through inflation. This will be the main cause of inflation over the next 3 to 5 years.

2. Rise in production cost of goods, for example, increases in raw materials and / or labor cost. There will be very little or no increase in labor cost over the next 3 to 5 years. Instead there will be downward pressure on labor cost during this period with jobs moving overseas and high unemployment. Cost of goods increases will stem from increases in the cost of raw materials, for example, corn, wheat, oil, natural gas, etc. There will continue to be increased demand for commodities in the emerging countries (for example, China and India) which will increase the cost of raw materials. Since commodities are one of the best investments when there is inflation, hedge fund managers and other investors will increase their investments in commodities, which will further drive up the price of raw materials.

3. Change in availability of supplies. The Arab Oil embargo of the mid 1970’s is a classic example of change in availability of supplies. The embargo caused an increase in the price of gas, paint, and other oil-based products. Inflation can also arise from speculation and increased demand from emerging countries. Of all the causes of inflation, this will be the wild card over the next 3 to 5 years. Oil is currently going up because of speculation. A major political event in the Middle East, Russia, etc. could drive up the price of oil to $150 a barrel or higher. For example, Iran is bombed by the US or another country seeking to destroy their nuclear power plants.

4. The consumer demands more goods and services than are available. This can lead to the seller increasing the price of the good or service and driving up the rate of inflation. I don’t see this being a factor driving inflation over the next 3 to 5 years.

5. Inflation can be artificially created through a circular demand by workers to increase wages (for example, because a change in supply increases cost of goods) which causes an increase in production costs which increases prices and leads to further demands for higher wages. This will not occur in the current economic environment. With the high unemployment rate and with the ability of companies to move jobs overseas, workers simply do not have the power to demand wage increases.

Employment analysis:

The total number of unemployed US workers is 15 million (this is the U3 number – see definition below) out of the total work force of 154 million (unemployment rate is 9.7%). If you want to decrease the unemployment rate to 5%, there would need to be more than 7.3 million new jobs created. If the US increases new jobs by 300,000 per month (factoring in 100,000 new employees entering the work force every month) it would take 36 months to get back to 5%. U6 unemployment rate is around 20%. That is another 15 million workers over and above the U3 number. If only 50% of these workers enter the work force, that is still 7.5 million workers. Including the U6 workers it will take 72 months (6 years) to get back to a 5% unemployment rate. If the job growth is 200,000, it will take 144 months (12 years) to achieve 5% unemployment. At no period in US history have we been able to generate job growth at 300,000 for a sustained period of time. It is going to be very difficult to grow jobs at this rate with so many jobs going overseas because of lower labor cost. The unemployment rate will decrease slowly over the next 3 to 5 years.

• U1: Percentage of labor force unemployed 15 weeks or longer.

• U2: Percentage of labor force who lost jobs or completed temporary work assignments.

• U3: Official unemployment rate per ILO definition.

• U4: U3 + "discouraged workers", or those who have stopped looking for work because current economic conditions make them believe that no work is available for them.

• U5: U4 + other "marginally attached workers", or "loosely attached workers", or those who "would like" and are able to work, but have not looked for work recently.

• U6: U5 + Part time workers who want to work full time, but cannot due to economic reasons

Summary:

Over the next 3 to 5 year period there will be an increase in the inflation rate driven by the money supply increasing faster than the real GDP, increases in commodities prices driven by increasing demand of emerging countries and speculation, and the US government wanting higher inflation to pay off the debt of the US government. The unemployment rate will slowly decrease over the next 3 to 5 years. For the next 3 to 5 years, we will be in a period of stagflation.

In next week’s blog I will be talking about best investments for stagflation. Please chime in with comments about my future economic forecast and best investment opportunities for that economic environment.

© 2010 Paul Cusick

Paul