Biflation or Stagflation? It Could Be Both

Includes: DUG, GLD, MOO, OIL, TIP
by: Matthew Green

On this website, particularly in the past few days, there has been an emerging discussion concerning biflation. The debate is rooted in the current US economic situation and the changing geography of the global economy. Politicians and economists the world over continue to argue about whether their own economies, and the world economy as a whole, are facing inflation or deflation. Among these debates, the term “biflation” has emerged. The knee-jerk reaction of many has been to simply dismiss biflation as being stagflation all over again. However, there are clearly defined differences that are crucial to the identity of each scenario within economics. In short, it is possible that biflation and stagflation could occur at the same time, as their definitions do not completely overlap.

The concept of biflation is relatively new, initially outlined by the economist F. Osborne Brown in 2003. It is an emerging concept, and therefore many economists are in disagreement with regard to its definition. In spite of that, several private economic research organizations have loosely defined biflation as an economic scenario where inflation of commodity-based assets occurs alongside the deflation of debt-based assets. Therefore, biflation itself pertains to the price action of goods, and does not take into consideration the overall performance of the economy it takes place within.

The definition of stagflation is different in nature. It incorporates overall negative or stagnating economic performance, coupled with price increases in nearly all categories. A long explanation about the historical Phillips curve and its interpretation before and after the 1970’s could be inserted here, but the supply-side cause will suffice. Stagflation is caused by a scarcity of supply across a sector or an entire economy, causing price increases and in turn reducing economic growth. Therefore, it is possible that both parties could be right in this debate. The US could potentially experiencing both biflation and stagflation in the coming years. However, for this to transpire the outcome of the biflation scenario must be inflationary overall, despite price deflation in some sectors.

As is well known, economists and commentators have argued that the money supply injected into the economy by central banks worldwide will lead to higher inflation in the future. If the economy goes through a biflationary stage, this is destined to be at least partially correct. The prices of commodity-based assets such as food, oil, and metals will increase. With the developing economies in Asia, demand for such assets will continue to grow. This translates into further price increases in the future. As a prime example, we have seen oil continue its robust recovery from the violent, margin-induced selloff of late 2008 (refer to chart). The price of oil is now near where it was in mid-to-late 2007, when the S&P 500 reached its all-time high. Until it dropped in the first week of May, talk of $100/barrel oil was reemerging for the first time since the 2007-08 run-up.

Gold has recovered from its most recent slump and is hitting new highs, with Silver not far behind. Across the world, government statistical agencies are reporting increasing levels of inflation. As an example, in April India’s annual inflation rate for March was reported at 9.9%, up from less than 2% last September. Consequently, the Reserve Bank of India [RBI] announced its intention to continue the trend of raising rates in the foreseeable future. This sudden increase is not limited to Asia, but there have been mixed signals, particularly in Europe. Annual inflation in the UK rose to 4%, according to data released in March. This exceeded the Bank of England’s internal 3% inflation target. However, the most recent UK data released earlier this week suggests inflation will be stagnant.

Light Crude – Continuous Contract: April 2007-Present

Click to enlarge

Every new set of data that points to inflation seems to be offset by an accompanying set of data that suggests otherwise, leading to mixed conclusions. When the talking heads engage in this debate, the usual suspects are mentioned (the large housing glut, in addition to excess capacity in manufacturing, etc.) Additionally, the US economy has been held down by increasing unemployment and stagnant wages even as the economy has stabilized. With individuals and families cutting back on spending, a greater amount of household income is directed toward buying essential items. Therefore, large purchases (read: debt-based assets such as McMansions, automobiles, etc.) increasingly fall into lower demand. Prices for these items remain stagnant, if not decreasing.

The prospect of the US economy falling into a destructive cycle of deflation is a scenario that US fiscal leaders are willing to do nearly anything to prevent, up to and including debasing the dollar. Despite that, some deflationary risks remain. Many stories appearing in the financial media in the past several months have pointed out that despite foreclosures falling in number, the number of properties eligible for foreclosure has continued to climb through 2009. Fifty percent more US home mortgages are now seriously delinquent than in the depths of the financial crisis in late 2008. As of the fourth quarter, the rate was 9.67% compared to about 6% then (refer to chart). In fact, it is estimated that five to six million properties are eligible for foreclosure but have not been repossessed. A range of predictions have been put forth, but the median estimate of economists is that it will take approximately three years for the housing market to digest the excess housing inventory.

Seriously Delinquent US Home Mortgages 2005- Present

Deflationists are also supported by the lack of credit available to most small consumers and businesses, which continues to keep a lid on economic growth. As with the inflation camp, there are some who feel it is a sign of things to come. Gluskin-Sheff economist David Rosenberg, formerly of Bank of America, sees deflation as the “primary risk” to investments in the near future, noting that “it is truly difficult to believe inflation is going to be revived in the intermediate term.”

So what’s the verdict? I think it is reasonable to say that our economy is showing both ingredients of biflation, regardless of a universally-accepted definition, and preliminary signs of stagflation as well. The prices of oil and food staples are rising, so despite marginally positive CPI readings, inflation is higher within the sector of essential items. Simultaneously, the relative lack of credit is still a thorn in the economy’s side, and with the first-time homebuyer tax credit coming to an end there is potentially another down leg coming up in real estate. If figures begin to tilt to the deflationary side, central banks may increase their intervention once again, propping up sectors of the economy that are experiencing deflation but having the inverse effect on the inflationary sectors. Along with rising worldwide demand for food and commodities, it could become a vicious cycle of biflation, and indeed stagflation, until real estate begins to rise on a sustained basis, and rates are raised to the point that prices can be contained without impeding economic growth. Needless to say, the issue of raising rates with the situation at hand is, and will be, a heated debate topic if inflation does take over. Until then, the tug-of-war will continue in more than one way.

Disclosure: No Positions