Perfect Storm for the “S” Word

Stagflation. There, I’ve said it – the economic malaise that most economists and all governments are too timid to mention by name.

Stagflation. The made-up term to describe a weak, sputtering economy combined with spiraling inflation. This condition was first referenced in a 1965 speech by British MP Iain MacLeod who said, “We now have the worst of both worlds – not just inflation on the one side or stagnation on the other. We have a sort of ‘stagflation’ situation.” ^[1]

So what is stagflation and why is it so feared? A simple definition describing stagflation is the simultaneous occurrence of inflation and a general recession within a given economy. But hold on all you Keynesians, how can it be possible for an economy to suffer from low productivity and growth stagnation as well as rapid price increases and inflation at the same time? Stagnation and inflation are at total opposite ends of the economic spectrum, aren’t they?

Anyone even remotely interested in following economic news is used to hearing dire predictions from the financial doom-and-gloom gurus. If it is not fears of an impending recession leading to mass lay-offs keeping us up at nights, then it is the specter of inflation lurking just down the road threatening to reduce our retirement savings to nothing more than coffee money that leaves our heads spinning. However, we are not used to being warned about both at the same time. Well, at least those that were not around for, or cannot remember, the long line-ups for gasoline at stations throughout most of the Western countries during the early 1970s. The reality is that an economy can suffer from inflation and recession at the same time, but it takes an extraordinary shock to the financial system to make this happen.

Stagflation – 1970s Style

The last time we experienced true, unfettered stagflation, the shock to the economy was delivered in the form of the 1973 energy crisis. On October 17 of that year, as the Arab – Israeli War reached its midpoint, OPEC (Organization of the Petroleum Exporting Countries) – which consisted of many of the Arab countries exporting oil to the west – announced that they would no longer ship oil to countries supporting Israel.

This caused massive disruptions to North America and much of Europe as these countries relied heavily on oil from OPEC to power their economies. Energy costs soared and in Canada by way of example, inflation more than doubled in less than a year to 10% and unemployment jumped to over 9%.^[2] The U.S. and Europe fared no better and photos of service stations with “No Gas” signs hanging from the pumps is an enduring image of this period.

Stagflation All Over Again?

So, if some massive shock is required to turn what may be an ordinary, run-of-the-mill recession or bout of inflation into full-on stagflation, is there anything on the horizon that can equal the impact of the oil embargo of 1973? More and more, the answer is “maybe”, and it comes in the form of the subprime mortgage and liquidity crunch.

As of late December 2007, the full extent of the market credit woes and personal finance horror stories are still greatly unknown, but these will come into focus as 2008 unfolds. In the past few weeks, two Canadian banks announced several billion dollars in subprime-related write-downs; UBS has written-off more than $16 billion in subprime losses; and Central Banks in the U.S., Canada, England, and Switzerland have collectively made many more billions available for their respective banking systems to alleviate a growing lack of capital brought on by the credit fallout.

But this is where things get a little sticky from a Keynesian point of view. Central Banks have been increasing the money supply and cutting interest rates to ensure sufficient liquidity in the financial sector in the face of massive subprime losses. Financial institutions that do have cash reserves are hesitant to participate in inter-bank lending as the quality of collateral offered by firms looking to borrow funds remains questionable. There is also a siege mentality taking hold and institutions with cash reserves are hoarding funds in anticipation of more bad news in the new year.

In the U.S., new housing construction has dropped considerably with the construction of single-family dwellings falling to its lowest levels in sixteen years. This means massive losses in the construction trades as well as associated jobs that service the housing industry with even further losses expected next year.

“We’re only halfway through the housing shock,” notes Ethan Harris of Lehman Brothers in New York. “It’s just a matter of time before the weakness spreads to the rest of the economy.” ^[3]

Let’s see; very little liquidity in the system… this means companies and individuals are having difficulty financing new spending; unemployment seems set to increase… therefore fewer people will have discretionary income to spend on anything other than the basics; and the news looks even worse in the near future… this can’t be good for consumer confidence. Wow – looks like we have the makings of a good old-fashioned recession.

But what about the latest inflation reports? It seems we’re also seeing an increase in inflation, where U.S. results for November 2007 showed an annual rate increase of 4.3%. Charles Plosser – President of the Federal Reserve Bank of Philadelphia and a voting member of the Fed – noted in a recent interview that while the November results alone do not yet constitute a trend, the rise in inflation can be attributed to broad-based price increases “caused by increased global demand for goods and services”. ^[4]

Alan Greenspan has also suggested that the early warning signs of stagflation are evident today in the U.S. economy. In a recent interview – and in typical “Greenspan-speak” – the former Federal Reserve Chairman noted, “We are beginning to get not stagflation, but the early symptoms of it”. ^[5]

So while we may not yet be looking stagflation straight in the eye, we are at a critical point that could very well dictate our immediate future. Because of the deepening credit crunch, central banks feel compelled to continue to put money into the system when conventional monetary policy tells us that we should be doing the exact opposite to stave off the inflationary pressures bubbling to the surface. And this is why stagflation frightens policy makers. It’s like fighting a two-headed dragon – while you are taking on one head, the other one can turn around and bite you in the … well, let’s just say that implementing monetary policy that tackles both inflation and recession at the same time is a daunting task.

Investment Opportunities

There are two fundamental questions you must consider when looking at investment opportunities. Firstly, how bad is the subprime mess, and secondly, is there a real concern for inflation next year?

Pay close attention to any signals from the Fed and other major central banks. The call to cut interest rates remains and could grow louder as the subprime fallout continues. Also, look for changes in the inflation rate – the November rate may be just an anomaly, but if oil prices remain high and food costs continue to increase, the November results may be the beginning of a trend. There are many things that consumers can cut back on if they become too costly, but energy and food are usually at the bottom of the list.

Ultimately, whether or not the US can escape stagflation, even the best-case scenario for the economy is not all that great. Subprime losses will continue to be announced; credit woes are not even close to being resolved; and job losses are expected to increase as the housing industry struggles. In short, there is no compelling reason to be bullish with regards to the U.S. dollar.

Last thoughts on this topic for now – learn from history. The approach that lifted the U.S. out of the stagflation doldrums after several years of failed monetary policy was implemented by then Federal Reserve Chairman Paul Volcker.^[6] Despite earlier attempts by Presidents Ford and Carter, it was Volcker – during the first few years of Ronald Reagan’s presidency – who managed to slay the stagflation beast. Volcker and the Fed targeted inflation first and tightened the money supply through a series of interest rate hikes which topped out at nearly 20%. Obviously, this resulted in considerable pain for borrowers and mortgage holders, but once inflation was under control, the Fed then instituted a measured approach of interest rate reductions to bring rates back to more conventional levels, which kick-started the economy back to a path of recovery.

Will Bernanke and today’s version of the Federal Reserve look to the past for their cue? Can we see a return to interest rates not seen since the days of Reagan? It takes a great deal of courage and a strong sense of conviction to substantially raise interest rates to the levels brought in by Volcker, but one thing is certain; Bernanke and the other central bank leaders will be forced to deal with continuing fiscal challenges early in 2008. These things will play themselves out over time of course, but the big question will be if the cure is more painful than the disease. Now is the time for you to assess your present situation and to prepare a forex trading strategy that minimizes your risk.

References

1. ↑ Iain MacLeod (1913-1970) British MP, Speech to the British Parliament, 1965
2. ↑ Canadian Government website
3. ↑ Ethan Harris, Chief U.S. Economist, Lehman Brothers – Bloomberg News, December 14, 2007
4. ↑ Charles Plosser – Reuters News Service
5. ↑ Alan Greenspan – December 16, 2007
6. ↑ Paul A. Volcker (1927 – ) – Federal Reserve Chairman from 1979 – 1987