The Breakdown | Explaining Southern California's economy

Let the battle begin: Stagflation or 'Stuckflation'?

This CNBC video features the musings of Barry James, who manages the James Golden Rainbow Fund, which "seeks to provide total return through a combination of growth and income and preservation of capital in declining markets." More to the point, Barry was asked to consider whether we're currently experiencing a replay of the 1970s, a decade that will be forever known for "Saturday Night Fever," the Bicentennial, punk rock...and stagflation, a scary economic phenomenon that combines low growth and high inflation.

We certainly have the low growth part right now, even though the third quarter 2011 data showed that U.S. GDP was 2.5 percent, much better than expected. The high inflation side, on the other hand, hasn't really materialized. Our current rate is 3.9 percent, just slightly above the historic average of 3.38 percent. And this is with the Federal Reserve pouring money into the economy.

Think back to Economics 101 an the good old law of supply and demand. To get inflation, in the classic sense, you need to have too much demand for the supply, which drives prices up. At the moment, businesses aren't overproducing, and consumers are, for the most part, cutting back. It's hard to imagine the supply-demand imbalance that would drive up prices and generate inflation.

There's an equilibrium. But it's a gloomy equilibrium. I call it "stuckflation," a condition in which the economy is just muddling through.

James sees similarities between where we are now and where we were in the 1970s. Like me, he has come up with a new term to describe it: "pa-laise," a combination of paralysis and malaise. We feel terrible and we're afraid to do anything about it. (I guess he decided against "paralaise" because it sounds too much like "paralyze," or maybe a sandwich condiment...)

Presumably, however, he also sees inflation on the horizon. Given that the Fed has cut interest rates to near zero, I don't see how this can come about. However, a little inflation would be a good sign. It would indicate that demand is returning to the economy. In any case, the Fed has plenty of room to raise rates — something it says it won't do for another two years — if it gets worried that inflation is headed toward stagflationary late-1970s levels of 12 percent.

James also points to high P/E ratios in the stock market as being similar to the 1970s. He's right about that: P/Es were high in the early 1970s and fell through the decade. (A stock's P/E can be seen as a measure of whether it's expensive or cheap, and if all the P/Es of stocks in the S&P 500 are averaged, they can indicate whether the entire market is overvalued.) 

So are we headed to Stagflation 2.0, with inflation rising as the stock market stagnates and GDP struggles? Or are we looking at low GDP for a while with the stock market moving gradually upward, kind of splitting off from the rest of the economy and bouncing up and down as it has been lately, not really indicating anything except that it's unpredictable?

I think the latter — stuckflation. The market isn't telling us anything right now, except that it's not a...relaxing place to put your money. So I don't think we're in for a replay of the 1970s. But we could be experiencing a new variation of stagflation, in which the price shocks that deliver high inflation in the face of sluggish growth just don't happen.

I'm not surprised that CNBC spotlights an argument that the market still matters. But P/E ratios have been much higher than they are now over the past decade. If they move lower, they don't have that far to fall. But they do have a lot of room to rise.

What do you think? Can you combine an economic trend like inflation with a market factor like GDP to predict a return of the 1970s? Or have the markets become about nothing, ultimately, but themselves?

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