Stagflation Lurks, a '70s-Style Threat

Core inflation has fallen from above 12 percent in 1980 to a bit above 2 percent today.

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Oil shocks, gas lines, and high inflation have been kept at bay.

By SHARE

Alan Greenspan, who should know a thing or two about the subject, predicts inflation in the global economy in the years ahead could be a bigger threat than it is today. "There is little we can do to avoid the easing of global disinflationary forces," the former Federal Reserve chairman wrote in his recent book, The Age of Turbulence. "Episodes of higher interest rates will be required."

Greenspan warns that if the Fed is unable to wrestle inflationary forces down, the core inflation rate in 2030 will be "markedly above" its 2.2 percent pace in 2006. If he's right, the underlying calm that has buttressed American economic growth for the past quarter century may be in for some more formidable challenges. Since the mid-'80s, scary swings in output and inflation have been notably absent. Recessions or serious downturns in the United States, like those in 1991 and 2001, were mild by historical standards. Core inflation has fallen from above 12 percent in 1980 to a bit above 2 percent today. And, amazingly, it has stayed there as most of the developed world has followed suit. Economists call the period "the Great Moderation," an unprecedented stretch of stable output growth and tame inflation.

Bargain costs. The credit goes to vigilant and independent central bankers, structural changes like technological gains, and more open trade, plus some dumb luck. Economic shocks—like a world war or a '70s-style oil shock—simply haven't been as severe. At the same time, technological developments and the expansion of global labor markets to include billions of low-cost workers in emerging economies kept the cost of production in check.

It's a remarkable achievement. But could inflation be coming back?

Yes, argue Greenspan and some other inflation hawks, eyeing long-term shifts in the U.S. economy and the rise of Asia. That virtuous scenario of record American productivity spurred by stability and technological breakthroughs may be fading . At the same time, growing demand for scarce resources driven by the rise of emerging nations—especially China and India—is taking a bite out of the benefits of globalization. "I think we're going to see higher inflation in the next five to 10 years than we've seen in the last five to 10 years under the pressure of lower productivity growth and bumps in the road in Asia," says Harvard University economist Kenneth Rogoff.

Increased competition for resources is evident. Look at oil. Prices of crude may fluctuate after last year's ascent to near $100 a barrel, but it'll probably take another shift to greener technologies to remove the inflationary threat caused by high energy prices. But it's not just oil. Commodities have surged across the board. Prices for wheat, rice, corn, and other grains rocketed in 2007. In November, China's inflation rate hit 6.9 percent, an 11-year high.

Rising inflation chips away at the value of bonds and cuts into both corporate investment and consumers' spending. A little is manageable, but an extended stretch of inflation mixed with lower growth—the dreaded stagflation—can cause major damage to markets and the economy. The economy is not there yet, but Goldman Sachs notes jobless claims are edging up amid signs of higher inflation—worrying trends that could easily abate but will still draw heavy scrutiny over the next few months. Investors looking to shore up their portfolios against that possibility should consider adding inflation-protected treasury bonds via an exchange-traded fund like the iShares Lehman tips Bond fund or investments in gold or commodities that rise when price pressures build.

Emerging demand. The big question: Will developing nations' demand for resources offset the benefits of globalization that helped keep a lid on inflation for years? Morgan Stanley's Stephen Jen argues that the benefit of low inflation, thanks to cheap labor in emerging Asia, is indeed losing steam. He estimates that permanent oil price inflation of just 5 percent a year would be enough to offset the benefits of globalization for the United States. Oil price inflation has averaged 21 percent over the past five years.