How Will the Fed and ECB Cope with Stagflation?
By the Curmudgeon
“If it is not transitory, and I hope it is, then the weed of inflation grows and kills the garden.” Richard Fisher, Former President and CEO, the Federal Reserve Bank of Dallas
The prospect that inflation’s recent spike may be more than transitory, coupled with the possibility the economy will grow slowly, has raised the specter of “stagflation.”
This article examines the case for persistent stagflation in the U.S. and Europe. We also suggest it could get much worse if global central banks maintain their ultra-easy monetary policies.
The 1970s were characterized by low economic growth combined with higher inflation, commonly known as “stagflation.” According to Edward McQuarrie, a professor at Santa Clara University’s Leavey School of Business, stagflation in the U.S. was from 1966 through 1982. “The mid-1960s are when the inflation that we associate with the 1970s actually began, and the ills we associate with the 1970s didn’t end until 1982,” he says.
Over that 17-year period (from 1966 through 1982), inflation was much higher than during the post WW II period up until then, and real GDP growth was much lower. The consumer-price index averaged 6.8% annualized, for example, four times the 1.7% rate over the 1947-1965 period. Real GDP grew at just a 2.2% annualized rate between 1966 and 1982, less than half the 4.5% annualized rate over the 1947-1965 period.
The current mix of persistently loose monetary, credit, and fiscal policies has led to inflation accelerating. At the same time, concern over the Delta variant has precipitously slowed the U.S. economy. For example, Friday’s jobs report had many fewer jobs added than expected while wages rose across the board (see Peter Boockvar’s comments below).
Also, Federal unemployment benefit programs under the CARES Act ended on September 4, 2021, which will decrease aggregate demand for many consumers. Don’t forget that consumer spending makes up about 70% of U.S. GDP.
Compounding the problem, medium-term negative supply shocks (e.g., semiconductors) will reduce potential economic growth and increase production costs. That’s a recipe for 1970s stagflation.
Consumer Confidence at Multi-Month Low:
The Conference Board’s Consumer Confidence Index declined to 113.8 (1985=100) in August, down from 125.1 in July. The Expectations Index—based on consumers’ short-term outlook for income, business, and labor market conditions—fell to 91.4 from 103.8.
“Consumer confidence retreated in August to its lowest level since February 2021 (95.2),” said Lynn Franco, Senior Director of Economic Indicators at The Conference Board. “Concerns about the Delta variant—and, to a lesser degree, rising gas and food prices—resulted in a less favorable view of current economic conditions and short-term growth prospects. Spending intentions for homes, autos, and major appliances all cooled somewhat; however, the percentage of consumers intending to take a vacation in the next six months continued to climb. While the resurgence of COVID-19 and inflation concerns have dampened confidence, it is too soon to conclude this decline will result in consumers significantly curtailing their spending in the months ahead.”
BoA Global Research – Stagflation Trades Gather Momentum:
In a report last week, BofA strategists said the latest evidence suggests inflation will not be transitory and there are stagflation risks that could complicate the Fed’s normalization of interest rates.
Investors have swept into assets perceived to perform well on slowing growth and rising inflation, with tech stocks seeing their biggest inflows in six months and large outflows from U.S. government debt. At $2.5 billion, tech stocks saw the biggest inflows since March 2021, while outflows from U.S. Treasuries rose to $1.3 billion for the week – their highest since February 2021 - as "stagflation" trades gathered momentum.
The chart below looks at the global economy,
including the U.S. and Eurozone, showing “inflation surprises have moved well
above overall data surprises.” That’s particularly so in the U.S., according to
the BoA report.
BoA said the “worsening Covid situation” could lead to “further deterioration of supply bottlenecks and higher inflation.”
“The risk is increasing that Covid, as a negative and more persistent supply shock, leads to stagflation, in turn making Fed policy normalization challenging,” the strategists wrote. “The market does not appear to be too concerned about Covid and inflation risks.”
The bank sums it up somewhat cryptically (emphasis added):
“On recession = bubble: global macro unambiguously stagflationary; but markets trading "H2 growth pause to pass with Delta" and/or "poor macro = no taper = age of infinite central bank liquidity to continue" despite inflation surge (EU PPI +12.1% YoY, highest since 1970s); risk of Fed-induced bubble to keep growing in absence of >1 million payrolls & >$3tn Democratic reconciliation fiscal package.”
Mario Monti’s Opinion:
Former Italian Prime Minister Mario Monti told CNBC Saturday that he believes the greatest threat to Europe’s economic recovery from the coronavirus pandemic is “stagflation.”
Monti, now the president of Italy’s Bocconi University, said the “huge mass” of accommodative monetary policy by central banks and fiscal stimulus from governments, implemented to support economies amid the coronavirus pandemic, “may well fire more inflation.”
Monti said that economies, not only in the EU, could start to experience elements of “stagflation” similar to that seen in many countries in the 1970s. Therefore, it will be “very important to manage wisely and in a coordinated manner this transition from a needed abundance of monetary and financial support to a more ordinary situation.”
Muted Policy Response Augurs for More Inflation:
After Friday’s disappointing jobs report, it seems the Fed will defer tapering and maintain its accommodating, easy monetary policy (“free money party”) for longer than it should. Of course, that risks ever higher inflation (i.e., it is not likely to be “transitory”).
As we’ve stated many times, each Fed chairperson seems to be more dovish than the previous one. That’s depicted below:
Image Credit: Hedgeye
If inflation stays higher than targeted and the Fed tapers QE too soon it could cause bond, credit, and stock markets to crash. That would subject the economy to a hard landing, potentially forcing the Fed to reverse itself and resume QE. Of course, the Fed has done that before, but the next downturn would be bigger and much more threatening.
Fiscal policies are also likely to remain loose, judging by the Biden administration’s $3.5 trillion infrastructure plan. Also, the likelihood that weak Eurozone economies will run large fiscal deficits through 2022 while the inflation is accelerating (Euro-area inflation was 3% YoY in August, up from 2.2% in July and a 10 year high).
Another Wage-Price Spiral?
One defining characteristic of the 1970s was cost-push inflation, when wages—employers’ biggest cost—and overall consumer prices chased each other higher, says Peter Boockvar, chief investment officer at Bleakley Advisory Group. “We are beginning to see tinders of a wage-price spiral,” he says, pointing to a 0.6% rise in average hourly earnings from July, a 4.3% increase in wages from a year earlier, and comments on Thursday from the National Federation of Independent Business (NFIB) report on small businesses.
50% of small business owners reported unfilled job openings in August on a seasonally adjusted basis). August's reading is 28 percentage points higher than the 48-year average of 22%.
“Small employers are struggling to fill open positions and find qualified workers resulting in record high levels of owners raising compensation. Owners are raising compensation in an attempt to attract workers and these costs are being passed on to consumers through price hikes for goods and services, creating inflation pressures,” NFIB chief economist Bill Dunkelberg said in a statement.
Nouriel Roubini argues that persistent negative supply shocks threaten to reduce potential growth, while the continuation of loose monetary and fiscal policies could trigger a de-anchoring of inflation expectations. The resulting wage-price spiral would then usher in a medium-term stagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflation inspired debt crisis will continue to loom over the medium term.
How will the Fed and ECB respond if the markets suffer a shock (or meltdown) amid a slowing economy and higher inflation?
“As I watch the asset bubbles get bigger and bigger, I can't help but think of Alan Greenspan's parting words before he left the Fed: ‘History has not dealt kindly with the aftermath of protracted periods of low-risk premiums.’”
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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