It's time to dust off my stagflation call, which has been out of the money for much of this year. For some time now, I have worried that the Goldilocks era of strong growth and low inflation in the global economy would give way to a period of slower growth and higher inflation. Almost a year has passed but my worries have not materialised: Goldilocks has prevailed with the economy growing beyond expectations and global inflation decelerating somewhat after accelerating going into 2005.
However, recent economic data, combined with the rise in energy prices this summer and the likely policy reactions in Washington to Hurricane Katrina, have firmed my belief that the global macro environment will turn stagflationary soon. If so, currently flat yields curves should steepen, currently tight risk spreads should widen, inflation-protected assets should appreciate, and volatility should rise.
Stagflation typically results from a mixture of overly expansionary macro policies that stimulate aggregate demand, and shocks and developments that reduce the economy's productive potential negative supply shocks. As I see it, there are three factors that are likely to weigh down on the supply side of the economy.
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The first factor is the energy shock, which was already a tall order before Hurricane Katrina hit and has taken a new dimension as the hurricane has severely damaged refining capacity. Taking on board energy price developments and Katrina, our economics team has lowered its sights on US and global GDP growth for this year and next.
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The slowdown in US productivity growth from the lofty heights reached in 2003 is the second factor. It is virtually impossible to tell whether this is just a cyclical or a secular slowdown, and what the underlying productivity trend is. My own guess is that productivity growth will revert back towards its 1.5% or so long-run trend as the IT revolution, which has pushed productivity above the historical norm since 1995, appears to have largely run its course.
Slower productivity growth means slower potential output growth and, unless wage growth decelerates as well, rising inflation pressures. Note that strong worker compensation growth and slowing productivity growth have combined to push US unit labour costs up by 4.2% in the year to the second quarter. Together with rising energy prices, this is likely to push inflation higher.
Third, for some time, there has been a worrying resurgence of protectionism and anti-market sentiment. Both in the US and in Europe, calls for protection from cheap Chinese imports have become louder. Moreover, the appetite for further market-oriented reforms in Europe has clearly dwindled. Just as de-regulation and globalisation were helping to push inflation lower and lift economic growth over the past decade, protectionism and re-regulation would strengthen the stagflationary forces resulting from the oil shock and the productivity slowdown.
To be sure, negative supply side shocks in themselves don't necessarily lead to stagflation. While such shocks produce stag', whether they lead to flation' very much depends on the response of monetary and fiscal policy makers to these shocks, and on the extent to which these shocks and the policy responses influence inflation expectations. So far, inflation expectations in the United States have remained well-anchored as the Fed has responded to solid growth and the pick-up in headline and core inflation over the past year by raising interest rates by a total of 250 basis points.
However, given its dual mandate of pursuing maximum sustainable economic growth with relative price stability, the Fed is likely to stop tightening as soon as there are clear signs of a more protracted economic slowdown. In my view, the Fed will stop short of tightening into an economic downturn and would rather accept somewhat higher inflation to keep a highly leveraged economy afloat.
Moreover, fiscal policy look set to become more expansionary again in response to Hurricane Katrina, with both government spending and the budget deficit likely to be larger than previously thought. Such a combination of expansionary monetary and fiscal policies with negative shocks affecting the supply side of the economy is a sure recipe for a stagflationary outcome, I think.
Of course, I'm not looking for a repeat of the big inflation of the 1970s. Policy makers will avoid the big policy blunders of the 1970s. Trade unions are less powerful and global competition is tougher now. But even a mini-version of the 1970s experience, which is likely in my view, could cause real damage in the bond market, given how complacent investors seem to be about inflation risks. The going assumption appears to be that, in a globalised world, there can be no meaningful, sustained pick-up in core inflation.
In other words, most observers assume that there will be virtually no second-round effects from higher energy prices and other price shocks. To me, this view is overly optimistic, especially as US labour compensation growth is already quite strong and productivity growth has slowed. As a result, unit labour costs were up 4.2% in the year to the second quarter. While it may be difficult for manufacturing firms to pass on such cost increases, those sectors that are less exposed to international competition large parts of the service sector are likely to see stronger price increases.
In Europe, I also see significant scope for a bout of stagflation over the next 6-12 months. The economic recovery is extremely fragile as it rests mainly on exports while domestic demand has remained weak. Our European economics team now expects GDP growth to remain below trend in the next several quarters, which is in line with my own hunch.
At the same time, higher energy quotes and the lagged effects of the euro's depreciation since the start of the year are likely to push inflation further above the European Central Bank's 2% limit in the remainder of this year.
True, core inflation has remained subdued so far. However, wage growth bottomed out late last year and has picked up moderately since, and productivity growth has slowed, which suggests that core inflation may creep higher, too. Moreover, consumer surveys indicate that the public's inflation expectations, which had been very low in recent years have picked up significantly.
Thus, in addition to what I've labelled type-II stagflation' economic stagnation with asset price inflation I think Europe is about to experience a good dose of old-fashioned type-I stagflation' in the period ahead.
Real bond yields are extremely low already, suggesting that bond markets are already factoring in a significant slowdown in economic growth. However, bond markets are not yet priced for a significant pick-up in consumer price inflation. So, the flation' part of stagflation should come as a bigger surprise for bond investors than the stag' part. How should investors position themselves for stagflation?
Avoid the intermediate and long end of the bond market, where the inflation premium is too low. I'm assuming that the Fed would not react aggressively to stagflation as it would not want to push a weakening, highly-leveraged economy over the recession edge. Hence, the short end of the US bond market should remain well supported.
Inflation-linked bonds still look attractive to me relative to nominal bonds. I expect break-even inflation rates to rise by about 50 basis points in the US and by about 25 basis points in the euro area.
Credit spreads have remained extremely tight in recent months, and I don't think this is sustainable once the signs of economic slowdown become more apparent. High yield looks especially vulnerable to me.
As the macro environment morphs from Goldilocks into stagflation and the uncertainty about the monetary policy responses will likely rise, volatility in the various asset classes looks set to pick up.
There is one important caveat here: if stagflation is the next big thing, global monetary conditions are likely to remain easy. This is because central banks are unlikely to tighten into a slowing economy even if inflation picks up. Global excess liquidity the ratio of money to nominal GDP is at record highs and is likely to limit the damage that stagflation could afflict on financial markets. That's why I'm cautious on bond and risk spreads based on my stagflation view, but not mega-bearish.
By Joachim Fels, Morgan Stanley economist, as published on the Global Economic Forum
