Commentary > Bid and Ask
A stagflation forecast
Is the Treasury market forecasting a return of the 1970's malaise?
November 20, 2003: 10:13 AM EST
By Justin Lahart, CNN/Money Senior Writer

NEW YORK (CNN/Money) - Stagflation, that dangerous mix of high inflation and low growth that socked the U.S. economy back in the 1970s, isn't on anybody's radar screen these days.

Except, apparently, the bond market's.

Over the past several months there has been steady buying in Treasury inflation-protected securities, or TIPS, the returns of which rise and fall with inflation. As a result, the spread on the yield between 10-year TIPS and 10-year Treasurys has grown to 2.37 percent from around 1.75 percent back in June. The spread is near its widest levels since 2000.

A relatively new asset class, buying TIPS makes sense if you are worried over the prospect of a rise in inflation; if you expect falling inflation or, worse still, deflation, TIPS are not a good bet. The Fed is worried about the latter scenario but some big investors are more worried about the former. Bill Gross, the bond manager who overseas PIMCO's more-than $250 billion portfolio, has said he is an active buyer of TIPS.

At the same time, however, the yield on the 10-year Treasury, at 4.2 percent, is actually quite low. That suggests a forecast of a less than robust economic environment in the years to come -- one where the Federal Reserve will not see fit to raise rates by all that much.

Put the rising TIPS spread and low Treasury yields together and what do you get? That's right: a forecast of stagflation.

One doesn't have to look very hard to find similarities between the early 1970s and now. Back then, as now, the U.S. economy was coming off a long boom that had fed into investing excesses. (Not that the enthusiasm for nifty fifty stocks was anything like what we saw in 1999.) The dollar was falling. Commodity prices were rising.

The kicker was the Arab oil embargo in 1973 and 1974, which led oil prices to quadruple. Uncomfortably high as oil prices are now, nobody expects anything of the sort to happen.

But there has been a groundswell of trade protectionism that many economists find worrisome. The White House's decision to impose quotas on some Chinese textile goods Tuesday raised the rancor of China, which said it may appeal to the World Trade Organization and Wednesday put off an official trip to the United States to sign orders for U.S. farm products.

More troubling, some investors worry that China may scuttle some of its vast U.S. Treasury holdings in retaliation, a move that could hurt Treasury prices and the dollar badly. A falling dollar, because it lowers U.S. purchasing power, is inflationary.

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And what of growth? The nation is still, unfortunately, awash in excess production capacity, operating at only 75 percent of potential.

Before the recent recession, you have to go all the way back to 1983 to find a period when capacity use was so low. If the United States was a closed economy, one would view this as an environment that would create little growth and little inflation. But since the U.S. economy is open to the world, and open to inflationary pressures from abroad, maybe what we get is stagflation.

All very frightening, right?

Let's take a step back. Much of the reason there's been so much interest in TIPS lately may have nothing to do with worries about inflation. Rather, as an emerging asset class, big investors are just figuring out how to play the securities into their asset mix. A big pension fund goes from not using TIPS to, say, a 3 percent position and things move. What superficially looks like a stagflation forecast may, in fact, be something very different.

Which isn't to say we shouldn't keep our eyes on this stuff.  Top of page

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