From Deflation To Stagflation: Stagflation Risks In Major Economies

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by: Hedged Equity

Summary

As the global economy continues to struggle with a weak recovery, the question is whether the age of deflation will now be replaced by stagflation?

The proposed economic policies under the Trump Administration can make or break the economy.

Brexit threat did not affect growth significantly but will most likely create a negative impact in the next two years.

In the final quarter of 2014, the Organization of Petroleum Exporting Countries (OPEC) made a decision not to limit oil supply amidst rising competition from the US shale oil production. As a result, oil surplus weighed down on fuel prices in the global market. For the next two years following that decision, fuel prices were on a downtrend losing more than 60% (at their lowest point) of their value from their peak in 2014. But fuel is not the only commodity that has seen falling prices in recent years. Steel has seen some major drop in prices from 2015 to 2016, and at its worst, lost 75% of its value. Other industrial commodities such as iron and copper suffered the same fate as weaker demand resulting from the global financial crisis persisted.

The falling prices would have been an opportune time to help the recovery of troubled economies. However, significant recovery did not happen for most nations as the drop in prices did not create sufficient increase in spending. As a result, deflation persisted in some economies while disinflation prevailed in others. But the recent move from OPEC is about to change the inflation trajectory. In the final quarter of 2016, OPEC members agreed to a supply cut of 1.2 million barrels per day (bpd) followed by an additional cut of 560,000 million bpd from non-OPEC member nations. The initial market reaction led crude oil prices to USD50 bpd and went up further to USD54bpd before the close of the year. These movements alone resulted to stronger prices in the final month of 2016, with inflation rising to its highest in more than two years. Rising fuel prices have recently ended the deflation for some major economies while a major acceleration was observed in others. As the global economy continues to struggle with a weak recovery, the question is whether the age of deflation will now be replaced by stagflation? The following looks into the stagflation risks in the US, Euro Area, China and Japan.

USA

Deep in its recession, USA fell into deflation in 2009. As the economy recovered, so did prices. In 2015, US fell to a mild deflation in the first quarter mainly as a result of fuel price movements in the global market. Fortunately for the US, the deflation was short-lived as the year marked the strongest economic growth since the financial crisis. Consumer spending advanced at an average of 3.2% as prices inched up by only 0.1%. The year also marked the first rate hike since the crisis following the end of quantitative easing the year before.

But 2016 felt the burden of the higher interest rate and the absence of quantitative easing. Consumer spending growth has decelerated and so did economic growth, with the full year expecting an average growth rate of 1.5%. The coming year promises more uncertainties for the US as they transition to a new government. Prices will rise as global fuel prices go up and another rate hike may just be on the horizon to cushion a sharper inflation. The proposed economic policies under the Trump Administration can make or break the economy. If the recent trend is to be followed, rate hikes will simply dampen economic growth but not inflation potentially leading to stagflation. However, the US may be able to avoid stagflation as the US dollar sustains its strength. The currency has recently seen an uptrend as a result of the rate hike and a weak European economy. The stronger dollar can potentially dampen some of the upward pressure in inflation, but the economic outlook remains weak as the nation faces uncertainties emanating from the government transition.

Euro Area

Similar to the US, the Euro Area has yet to fully recover from the financial crisis of 2009. With the area continuously weighed down by troubled member-nations, economic growth has remained anemic barely escaping a contraction. In 2009, the economy suffered a sharp recession averaging -4.5% and with it came deflation. While a recovery ensued the following year, it was short-lived as the area reverted back to a recession in 2012 and 2013.

In 2016, periods of deflation have been recorded despite positive economic growth. Following OPEC's announcement in the fourth quarter, inflation jumped by more than 1% - the highest in two years. Despite the acceleration in prices, economic growth is stagnating at 1.7% while unemployment remains significantly high at an average of 10%. The year (2016) is expected to post a weaker growth than the year before with the economies of Greece, Italy and Cyprus mainly pulling down the Area's economic performance. Brexit threat did not affect growth significantly but will most likely create a negative impact in the next two years. As the economy stagnates, the Euro weakens aggravating further the higher inflation brought about by fuel price movements. The area may raise interest rates from its current negative value to a positive one in order to prevent a massive acceleration in inflation rate. However, this will be done at the expense of the economy leading the Area to stagflation.

Japan

Japan has struggled with deflation for more than a decade prior to the financial crisis of 2008. When Japan was hit by a recession in 2009, deflation resurfaced soon after and lingered persistently for more than three years. The economy was on its way to recovery when the 2011 Tsunami occurred, stunting growth and changing its general trajectory. In order to combat an ailing economy, PM Abe embarked on a series of fiscal expansion, monetary easing and structural reform. Economic growth breached 2% in the years following the expansionary policies but deflation lingered as consumer spending remained cautious. With a target inflation rate of 2%, PM Abe decided to raise the sales tax which has the ability to augment their worsening fiscal stance and raise inflation. But the sales tax hike resulted to a sharp drop in consumer spending paired with a higher inflation rate. In the absence of a strong demand, the nation fell back to deflation as global fuel prices began to decline and the effect of the sales tax hike has leveled off.

In 2016, deflation averaged -0.2% as a result of the weak economy, weak spending and weak commodity prices in the global market. In September, PM Abe announced another round of stimulus package to help the economy that is seriously showing signs of a possible contraction. The same stimulus package is likewise expected to meet the target inflation rate of 2%. But what Japan did not anticipate is that just months after their announcement, OPEC would decide to cut supply thereby raising fuel prices. The stimulus package and oil prices combined can potentially raise inflation rates beyond target. Despite the recent postponement of the second round of the sales tax hike, consumption spending remains weak and cautious. The imminent acceleration in prices will not do the latter any good and may in fact, push spending down even further. All indicators are pointing to an era of stagflation following a desire to end deflation. Just like Europe, interest rates may be raised to prevent acceleration in prices but this will lead to an even weaker economic growth.

China

For China, the financial crisis resulted to a slowdown as the nation recorded its first single digit growth rate in nearly a decade. Despite the slowdown, China's economy managed to sustain an enviable growth especially for nations under a recession. Even with a relatively stronger growth, China did not escape deflation. In 2009, prices fell at an average of 0.7% reinforcing speculation that growth is hardly driven by domestic demand. Economic growth immediately recovered but has since slowed down due to structural reforms and weaker demand from abroad. As fuel prices fell in 2015, China missed its inflation target but avoided deflation due to a depreciating currency and rising domestic demand.

China's slowdown is expected to continue in 2017 as they continue to reduce overcapacity, cut inventories as well as production costs. Economic growth is expected to run at 6% to 6.5% for the year, while inflation target remains at 3%. Inflation may see some acceleration but China's fuel reserves acquired for the last two years will certainly cushion the possible acceleration in prices. As such, stagflation is not likely to happen in China even with a depreciating Yuan and an economic slowdown. More importantly, China's fiscal position will allow the government to come to the rescue when extremely necessary.

Among the nations mentioned above, stagflation risks are strongest in the Euro Area and Japan. Both nations have negative interest rates that may be raised to diminish the acceleration in inflation. However, given the weakness in their respective economies, raising interest rates may have more effect on economic growth than inflation. OPEC's decision to cut oil supply has the potential to create a stagflation trap especially at a time when expansionary monetary and fiscal policies have been fully exhausted but failed to create sufficient growth momentum. Nations with weaker currencies are more vulnerable to the trap as prices are expected to accelerate at an even faster rate than nations with stronger currencies. Any policy change/shift that aims to curb inflation will simply dampen an already weak economic growth.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article from www.HedgedEquity.com is only for informational and educational purposes NOT investment advice.