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A not-so-fun 'stag' party?
Investors are very worried about rising rates -- and sluggish growth. Is stagflation a threat?
April 28, 2005: 9:35 AM EDT
By Paul R. La Monica, CNN/Money senior writer
Bears run wild: Fears of inflation, a weak economy and sluggish earnings growth have sent stocks reeling this year.
Bears run wild: Fears of inflation, a weak economy and sluggish earnings growth have sent stocks reeling this year.
What inflation? The recent dip in yields for the 10-Year Treasury is a sign that the bond market is more worried about a slowdown than inflation.
What inflation? The recent dip in yields for the 10-Year Treasury is a sign that the bond market is more worried about a slowdown than inflation.
How should the Federal Reserve respond to the latest report showing a boost in consumer inflation?
  Increase the pace of rate hikes
  Hold current rate-hike policy steady
  Stop raising rates
  Await more reports

   View results

This is an update of a story that originally appeared on April 21.

NEW YORK (CNN/Money) Investors are doing a lot of worrying lately. Some are biting their fingernails about rising interest rates and higher inflation, while others are gnashing their teeth about signs economic growth is slowing.

It would seem at least half these nervous Nellies have to be wrong. After all, inflation usually accompanies strong growth, so if prices are heating up, the economy shouldn't be slowing down. And if the economy is slowing, that should mean muted inflation.

But some veteran market watchers say both camps could be partially right. These fears rose to the forefront on Thursday following the release of the gross domestic product (GDP) report for this year's first quarter.

The report showed that economic growth was lower than economists predicted and also indicated that inflation, as measured by a reading on personal spending that the Fed pays close attention to, could be more of a threat than expected.

And that doesn't bode well for stocks, which, despite a rally Thursday morning, are still not far from their lowest levels of the year.

Prices for oil and other commodities are high -- putting upward pressure on prices throughout the economy. There's no denying that.

The Federal Reserve has said as much in the notes from its last meeting and again in its "Beige Book" survey of regional economic conditions, issued last week. Meanwhile consumer prices for March, excluding oil and food, rose at double the rate of forecasts and at the highest rate in nearly three years.

At the same time there are clear signs the economy is slowing. Retail sales were sluggish in March. The trade deficit hit a record in February. And housing starts tumbled last month, a sign the torrid real estate market may be losing some steam.

More stag, less 'flation

"Inflation trends have been going up and are now getting to the upper end of what the Fed is comfortable with," said Steve Van Order, chief fixed-income strategist with Calvert Funds. "But it definitely looks like the economy has at least temporarily slowed down."

That's not encouraging to some since it sounds an awful lot like the phenomenon known as stagflation, which is high inflation and weak, or stagnant, growth.

Stagflation was a huge issue in the 1970s, when double-digit inflation and weak growth, coupled with high unemployment, created a terrible environment for American business -- and the stock market. Fortunately, it doesn't appear a return to that type of stagflation is likely.

"The simple reason that stagflation is not a concern is that the 'flation' part is still benign," said Ashraf Laidi, chief currency analyst with MG Financial Group.

Laidi explains that despite the runup in oil prices, the Fed's favorite inflation indicator, the so-called core personal consumption expenditure (PCE) deflator, has remained within a range the Fed believes is reasonable.

But Van Order said the economy could be experiencing "stagflation lite."

And some think this muted stagflation could worsen because the Fed has its hands tied. Alan Greenspan and other central banks are first and foremost inflation hawks -- meaning they'll do everything in their power to keep pricing pressures at bay.

In Washington, Fed Chairman Greenspan warned Thursday that rising interest rates and a rising federal budget deficit, if left unchecked, "would cause the economy to stagnate or worse."

Oil and housing induced slowdown?

In any case, the Fed is likely to keep raising short-term rates to fight inflation. It's already boosted its federal funds rate, an overnight bank lending rate, to 2.75 percent, the highest in over 3-1/2 years, since last June. But more rate hikes could further slow growth, hitting the housing market and consumer spending, in particular.

"A slowdown is baked in the cake," said Michael Cheah, manager of the SunAmerica GNMA and SunAmerica U.S. Government Securities fixed-income mutual funds. "A big part of economic growth has been driven by consumer home-equity loans and if home prices are subdued, you won't have more loans driving spending."

Bond investors are clearly betting a slowdown is more likely in the near future than rampant inflation.

The yield on the 10-year Treasury has tumbled from 4.5 percent just three weeks ago to about 4.28 percent as investors flocked to the safety of government bonds -- and investments that tend to do better in a sluggish environment. Bond yields fall as prices rise.

"The bond market seems to be shrugging off existing inflationary talk, which means that investors are starting to worry more about the contractionary impact of higher oil prices on the economy," said MG Financial's Laidi.

SunAmerica's Cheah added that even if there's no broad pickup in inflation, high oil prices will mean more pain at the gas pump this summer, which could dampen consumer spending further. And oil prices are unlikely to tumble soon since India, China and other fast-growing countries have raised global demand.

More hikes = more volatility

With oil prices beyond its control, the Fed is likely to raise rates at it its next meeting in May and perhaps again in June to ensure inflation doesn't run amok, economists said. But after that, it's anybody's guess as to whether the central bank keeps raising or pauses.

Calvert's Van Order said that the recent signs of a slowdown could mean the Fed won't boost rates as high as many had previously thought. Many investors who had been expecting a fed funds rate of 4.25 percent now think 3.5 percent or 3.75 percent is more likely.

But the Fed is in an extremely delicate situation.

"If the Fed stops raising rates, the market will blame them if inflation gets too hot, and if they keep cranking up interest rates, then the real estate market is at risk. It's a somewhat challenging environment," said Barry Ritholtz, chief market strategist with Maxim Group.

So what does this all mean for stocks? Probably more volatility.

Higher rates and a slower economy could mean lackluster profit growth. To that end, earnings for the S&P 500 are expected to rise 11 percent this year and next, after a whopping 20 percent increase last year, according to Thomson/First Call.

"The big issue is decelerating earnings growth. Earnings will still be higher but the ideal time to buy stocks is when earnings go from awful to not so bad as opposed to going from great to good," said Ritholtz.

For more about the markets, click here.

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