In Anticipation of Stagflation

Former Fed Chairman Greenspan said on Sunday that the U.S. economy is showing early signs of stagflation. It looks like the financial media has quickly grown tired of writing about the recessions and all the associated doom and gloom, which is why they are itching to jump on the "stagflation" bandwagon. A few observations:

Policy dilemma: Stagflation presents a problem for central banks, as they need to decide which problem (growth/inflation) they should tackle first. Futures trading shows that the market is betting the Fed will remain focused on supporting growth. Some analysts say central banks should ignore the threat of inflation, since debt deflation poses a far greater risk. Graham Turner of GFC Economics says Japan's decade-long struggle to escape the grip of deflation was caused by the failure of its central bank to cut interest rates quickly enough. "Today, central banks in the west are fretting over the risks posed by higher oil and food prices. But the lesson from Japan should be clear."

The commodity market: Commodities traders have been pricing in a stagflation scenario. We have seen prices of oil and gold (inflation) rally over the last few months, while industrial metals (growth) has been falling sharply. Base metals are generally seen as highly sensitive to economic activity, while gold is seen as a precursor of more general inflation.

The (questionable) link between a weak greenback and inflation: The consensus is that a weak dollar fuels inflation, and the greenback's awful performance during 2007 may lead to inflation in 2008, which may increase the risk of stagflation. Also, a weak dollar doesn't help the economy because the U.S. is not much of an exporter relative to it's huge domestic economy. The greenback weakness of 2007 may well lead to inflation in 2008, and November's inflation data may have given us a preview of what's to come in 2008. But some analysts question the link between inflation and greenback weakness. A recent Wall Street Journal article explained that foreign exporters' willingness to adjust prices to hold on to U.S. market share is the main reason for the limited inflation we've seen since the U.S. dollar weakened.

Central bank trends could dent U.S. growth by raising interest rates: If China and other central banks continue to sell U.S. treasuries it would drive down bond values, thereby raising not only the effective interest rate on existing bonds but also the market into which new bonds were sold. Most models show that U.S. interest rates would soar if other central banks had to sell their holdings. A 2006 study by Professors Francis and Veronica Warnock at the University of Virginia showed that U.S. long-term interest rates would be about 90 basis points higher without foreign buyers. "The support that Asia has shown in buying U.S. Treasuries has been a major supporter of keeping long-term interest rates lower than where they probably would be," said Gary Pollack at Deutsche Bank. If foreigners had to exit U.S. debt positions, it "could put some upward pressure on yields in the United States."

Inflation may soon be China's fastest growing export: Some observers have suggested that China's exported deflation was the key reason why the world avoided a full-blown global recession after 2001, but this will not be the case in 2008. Until recently, the inflationary impact of China's booming oil demand was more than offset by the deflationary effect of cheap Chinese goods. So, on balance, China exported net deflation. But now China is grappling with growing inflation itself, export prices are rising too. So having played a crucial role in stemming global inflation for several years, the People's Republic is now imposing a "double inflation" effect on the rest of the world.

An urban legend and a final thought...

On Friday afternoon, May 17, 2002, a butcher named Edwin Lopez was alone in his downtown Los Angeles butchery. He was about to close shop for the weekend when he accidentally locked himself in a walk in freezer. He spent hours yelling and banging on the door, but to no avail. There was no way to open the freezer from the inside, and he quickly realized that he would freeze to death. He had a clipboard, some paper and a pen, and started writing messages to his loved ones as he surrendered to his fate. On Monday morning his workers found him dead. Not only do they find his final letters, but they also found out that the temperature in the freezer never went below 50. The tragic death of Mr. Lopez demonstrates the incredible power of the mind – he literally psyched himself to a freezing death.

Wall Street is trapped in a walk in freezer. The data shows that the temperature hasn't dropped below 50. Let's not psyche ourselves to a freezing death.