Analysis: Stagflation, 70s icon, dusts off disco shoes

Models chat on stage during a presentation of the design label Rock & Republic's Spring 2008 collection at New York Fashion Week, September 5, 2007.

NEW YORK (Reuters) - Nostalgia buffs of the 1970s should invest in vintage economic textbooks because stagflation may be the next retro-trend to make a comeback in the United States.

Soaring oil prices have raised concerns the economy could see a repeat of problems that marred the disco era, when inflation soared, the economy slowed and unemployment was high.

Indeed, some bond investors are showing signs of alarm. U.S. government bonds that offer protection from price growth now reflect the highest inflation expectations in around two and a half years.

"I hate to mention the word stagflation, but that seems to be what fears are out there at the moment," said Martin Hegarty, who co-heads the management of about $22 billion in global inflation-linked portfolios for BlackRock, the world's largest asset manager.

Hegarty sees inflation concerns as contained for now, though the rise in oil is threatening momentum in the economic recovery at the same time as a number of other economic headwinds are threatening the rosy outlook.

Some investors already feared an economic slowdown as the Federal Reserve approaches the end of its bond-buying stimulus program and U.S. federal and state governments come under increasing pressure to reduce spending.

The effect of higher oil costs on inflation, if sustained, could go either way. Higher costs could hurt consumer spending, bringing inflation down over the medium term. Or commodity prices could lead to general price increases.

So far, "I think the market is viewing this move in oil as more of a stagflationary tax. It's not going to result in inflation expectations becoming embedded in psychology, and the inflation genie is not going to get out of the bottle," said Hegarty.

Indeed, U.S. consumer price inflation is currently less than 2 percent, well below the levels of 1974, when it rose above 12 percent.

INFLATION EXPECTATIONS RISING

Signs are starting to emerge, however, that the market could be facing longer-term risks, and some fear the Fed will be too slow to respond.

So-called breakevens on 10-year Treasury Inflation-Protected Securities, which measure inflation expectations, rose as high as 257 basis points this week, their highest level since July 2008 and only 30 basis points shy of their all time high in 2005.

Forward contracts that measure market expectations of where five-year inflation will stand in five years, the Fed's favorite market inflation indicator, also increased by around 20 basis points to 280 basis points in less than two weeks.

"It would seem that the Treasury market is more worried about the Fed being too loose, too long," said Bob Gahagan, head of the taxable bond group at American Century Investments, who manages $21 billion in taxable bond assets.

"There is a risk of a stagflation environment, not stagflation like the 70s, but just very low subpar growth with inflation higher than the Fed's target," he said. "That would be very much a dilemma for policymakers. That's one risk that we're watching for."

JUST THE WAY IT IS

The trend may be global as some say other economies, including in the United Kingdom and Asia, are already stagflating.

"Stagflation is just the way it is," with low labor productivity, which may decline further, said Dominic Konstam, global head of rates research at Deutsche Bank in New York.

"The fact is we're now in a world where if you want to get lots of growth, you're going to have to pay the price in inflation, which means in the end that you're going to have to run the economy slower than otherwise," Konstam said.

"I don't think the market's fully adjusted to that, and I don't think the Fed's fully adjusted to that," he added.

The Fed could be forced to act, however, if a strong and sustained rise in inflation-linked bonds show that investors think inflation will get out of control.

"Inflation expectations are increasing, and that could very well put pressure on the Fed to give a signal of higher rates," or to talk of an exit strategy from its stimulus program, said American Century's Gahagan.

That would pose a dilemma for the central bank as it tries to balance its mandate to reduce unemployment and control high prices, or face an oily slide back to the decade of big hair, flared jeans and gas lines.

(Editing by Padraic Cassidy)