How Will the Fed and ECB Cope with Stagflation?
By the Curmudgeon
Introduction:
“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.
Backgrounder:
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.
Image Credit: Alex Hughes Cartoons
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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
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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.
Conclusions:
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?
End Quote:
“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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Stay healthy, enjoy
life, success, good luck and till next time….
The Curmudgeon
ajwdct@gmail.com
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the Curmudgeon on Twitter @ajwdct247
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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