A Dose of Stagflation
July 7th, 2008 - Warren Buffett says that he is worried about stagflation. “We’re right in the middle of it” he said, in an interview on Bloomberg. He is, of course, absolutely correct and leagues ahead of denizens of Wall-Street analysts and economists who only a short while ago were denying that it would ever occur. Stagflation, just to remind you, means a combination of slowing growth and rising inflation.
Unfortunately, this is just what is happening in America, Europe and many other places. And, as you may have guessed, it puts policymakers in a tough spot. They would very much like to boost growth by lowering interest rates and providing liquidity, but with inflation on the rise that is a risky thing to do. Worse still, expectations of inflation are increasing and, with it, the risk that they will become entrenched. How the central banks react to current conditions will determine economic prospects in the next few years and perhaps longer. Given the extent to which central bankers have hogged headlines, you are probably absolutely fed-up with any more talk about them. But we cannot ignore them if we are to understand how possible scenarios may unfold.
Leaving them out would be akin to discussing Hamlet without the prince of Denmark. Unfortunately, they have become principal actors in what are supposed to be self-regulating market economies. And what bad actors they are! We are not just referring to their public persona when making presentations, but their impact as economic agents.
The evidence is that they have, more often than not, been a cause of instability rather than stability in their effect on the economic and financial system. Many years ago, Milton Friedman, who was sceptical about the ability of policymakers to micromanage the economy, proposed a much more circumscribed role for central banks. Unfortunately, his proposals were never implemented and aren’t likely to be put into force at the present time.
Among major central-bank governors, Jean-Claude Trichet is the one with the greatest credibility in the financial markets. The European Central Bank president, early on, declared his intention to be tough on inflation. And with the Eurozone headline inflation rate well above the target, he really didn’t have much choice. But the good thing is that he has not shilly-shallied about the issue, despite getting flak from assorted bleating politicians.
He appears to have convinced investors of his readiness to prevent high inflation expectations from becoming entrenched. Mind you, with the headline Eurozone inflation rate running at 4 per cent and the ECB benchmark rate at 4.25%, the real rate is only just in positive territory. This hardly constitutes a very tight policy. But it is a whole lot more restrictive than the Fed’s stance.
The Eurozone economy has greater rigidities than the US, and the probability of a wage-price spiral taking hold is higher. Trichet has stated that he does not want to repeat the mistakes of the 1970’s when inflation was validated by central banks’ decisions to accommodate inflationary pressures. The consequences were very unpleasant because, eventually, high inflation rates had to be brought down by very tight monetary policies that caused costly recessions. To his credit, Trichet has drawn the correct lessons from the past: that it is smarter to act sooner rather than later to diffuse inflationary pressures.
Some people have objected that today’s circumstances are different from those of the past and therefore we do not need to worry too much. Well, to any observer, it is obvious that structures have changed. Unionisation is lower, exchange rates are more flexible and economies are more open than before. Furthermore, technology has changed in such a way that production processes require fewer units of material inputs per unit of output than previously.
But the latter contention holds primarily for developed economies. Developing ones are less energy efficient and use more commodity-intensive processes. And, of course, they are growing very fast, resulting in a huge appetite for total commodity imports.
In a global economy that is increasingly integrated and has rapid financial transmission mechanisms, the ability of a sovereign central bank to fully control the impact of its policies is limited. When the Fed started an aggressive easing of monetary policy, last year, there was a spillover of liquidity into already hot emerging markets, leading to even higher prices for oil and some other commodities.
This not only led to some pressure for the prices of exported manufacturing goods to rise but also fed the global psychology of inflation fear. With the Fed seemingly willing to debauch the currency, the outlook for stocks cloudy, and bonds facing the possibility of serious re-pricing, investors latched on to oil as a good alternative asset. This has led to a continuing rise in the price of oil. Essentially, the boomerang thrown by the Fed came back and smacked it right in the face, in the form of higher imported inflation.
It should be noted that the role of speculation in energy markets has been much exaggerated. But the politicians need scapegoats and are keen on organising witch hunts to assuage public anger. There are proposals in the works to further regulate and control markets for commodity derivatives. But this is a very bad idea, which will eventually lead to less optimal resource allocation.
Another interesting aspect of recent events is that it has become clearer that the Fed is not necessarily the leader in setting the direction of monetary policy that other central banks are forced to follow. In the past, what the Fed did was often copied by most other central banks. But this time, a major bank in the form of the ECB, did the opposite of its American counterpart. Even as the Fed kept monetary policy easy, the ECB maintained a tightening stance. And it was the Fed that was forced to blink.
Last month, after Trichet said that they would be tough on inflation, and the dollar fell sharply, Bernanke’s feet were held to the fire and he had to squawk about being concerned about inflation. It was an insincere statement that did not fully convince the markets. What the episode demonstrates, though, is the changing status of the Fed and the dollar in the global economy.
The ECB’s hard stance is, of course, hurting some of the European economies such as Spain and Italy. But their problems are not to be solved by monetary policy. In the first case, there is a housing bubble that has to correct further and in the second case there are long-standing structural problems that successive Italian governments have refused to address fully.
If we didn’t have the euro and the ECB the situation would be quite different today. France, Italy and Spain would have eased happily along with the Fed. What’s more, the French franc, peseta and lira would have been devalued. Meanwhile, the Bundesbank would have held tight and the mark, shilling and guilder would be appreciating.
The rise in commodity prices represents a change in relative prices and should not be inherently inflationary. In other words, we are making an analytical distinction between relative price changes and a change in the overall price level. The more an economy is characterised by flexible rather than fixed prices, the less is there the likelihood that there will be an inflationary impact. Be it noted, though, that oil is a particularly important commodity, as it enters into transportation, heating, fertilisers, plastics and so on.
To the extent that, currently, economies are more flex-price than fix-price relative to the 1970’s, the overall inflationary impact of rising commodity prices should be more subdued than in the earlier period. We should also emphasise that this applies to all prices, including exchange rates.
But it is common knowledge that many governments in the developing world are not very keen on promoting flexibility in exchange rates or in how some prices are set in the domestic market. This applies, particularly, to many large and fast-growing Asian economies. They use a mix of subsidies, controls and pegged currencies. As a result, there are distortions in the pattern of demand, as well as the transmission of an inflationary impetus to the global economy.
Of course, in many developing countries food and energy constitutes a big chunk of the average family budget and dealing with high prices becomes a much bigger political issue for the government than in the developed world. So, some form of intervention is inevitable.
But when all is said and done, the way in which rising commodity prices are translated into a continually rising price level is for the central bank to validate inflation by maintaining an easy monetary policy. That was what happened in the 1970’s and can happen again if the authorities fail in their duty to maintain the purchasing power of the currency rather than the purchasing power of households. The attempt to promote growth may end badly, as stronger measures may be needed down the road to shake out entrenched inflationary trends.
The rise in commodity prices results in a change in the distribution of income in favour of an assorted group of producers, including mid-west farmers in the US, soybean exporters in Brazil, oil producers in the Middle East and so on. In time, the price rise will encourage a degree of moderation in demand and increase in supply. However, subsequent to an expected near-term cyclical downturn, the long-term pace of growth in the emerging world may continue to be robust. So, trends in commodity prices may find renewed support when the global economy picks up again in the future.
As far as central bank policies are concerned, the US has an inflationary bias. So do China, India and several other Asian countries. Growth expectations are high in these countries and there is political pressure on the authorities to deliver on the implicit promise of rising living standards. The UK is somewhere in the mid-Atlantic between Europe and America. Latin American central banks, by and large, appear to be acting responsibly to contain inflationary pressure. Of course, in earlier years they fought hard to bring down perennially high inflation rates, and don’t want to go through that cycle again. So, summing it all up, global monetary policy is still too easy.
The turmoil in the capital markets that the authorities assured us was over some two months ago is still with us, and credit market contagion is again on the agenda. In the US, a slowing economy and falling house prices are forcing more write-downs by banks that are, then, forced to look for more capital to shore up dodgy balance sheets. Of course, many European banks aren’t spared these pains either.
With economic conditions still deteriorating, we may not have seen the end of the write-down cycle. Meanwhile, credit-rating agencies are being lambasted for dishing out ratings based on inadequate knowledge, poor analysis and an optimistic bias. In this credit-crunch period, their ratings have often been way off base.
Currently, they are under pressure to maintain investment-grade ratings on bond insurers Ambac and MBIA. If they drop ratings to below investment grade, this will cause further turmoil for the banks, not to speak of other entities. The whole thing is a sham because the market’s implied rating of the two companies, based on credit default swaps, rates them as junk. But Moody’s and S&P are still maintaining the phony ratings.
In the go-go years few people worried about counterparty risk, as the credit default swap market grew at a tremendous pace. Now, those who thought they had bought protection are more than a little concerned that they may not be able to collect if defaults occur.
Hedge funds, which have been busy in this market, may not have sufficient capital to meet payments. Many of the swaps are on below investment grade companies or indices of debt instruments. There is not much transparency in pricing and it is not entirely clear what is deliverable, even if those who wrote the protection have the means to pay up.
Speculators have had a field day in the CDS market over the past few years, while regulators slumbered. The CDS market is in total contrast with exchange-traded contracts, such as futures. In the latter case there is an organised and regulated exchange, with ready liquidity and transparency. All trades are pretty much guaranteed because the exchange always acts as the counterparty, taking the opposite side of each trade. Also, variance margins help to ensure that those with sufficient capital can continue to participate in the market.
American consumers have spent the money they received from the fiscal stimulus package. This was a brief and modest shot in the arm for lower-income households. Now, it’s back to reality: high fuel and food prices, weakening employment conditions, falling house prices, and lower real wages.
For all the growth in the US economy in the past ten or twelve years, the real median wage has been pretty stagnant. Rising inequality of income distribution has meant that the rich have got considerably richer, with the poor lagging behind. The average Joe is in a particularly bad mood in current circumstances. Low unionisation and a weaker labour market will make it difficult for him to keep inflation from eating away at his disposable income. So to fight back he is likely to turn his attention to pushing for greater protectionism, and that would be decidedly inflationary.
Bernanke will feel lonelier on the FOMC, as another member calls it quits. His academic soul-mate Frederic Mishkin is leaving next month to go back to the comfy world of university teaching. This is undoubtedly the smartest decision that Mishkin has made as a governor at the Fed. Why hang around when the going can only get tougher?