US Economy: Stagflation?

Economic data continue to point to ongoing growth of the US economy, but financial-market participants have become more doubtful. This was reflected in expressions of concern following the release of the latest US trade deficit figures earlier in April, and especially in the plummeting of stockmarket indices a week ago. Moreover, the latest industrial output and import-price inflation data have prompted the revival of a nearly forgotten term, "stagflation". While the Economist Intelligence Unit is not forecasting a scenario of high inflation and a stagnant economy, the combination of creeping price pressures and slowing growth has already arrived.

On the surface, US economic data remains generally upbeat. Retail sales rose 0.3% month on month in March, marking the longest spell of uninterrupted growth since 1999. Industrial production continued the steady increase seen since mid-2003. However, a closer look at the figures suggests a less rosy picture. Retail sales were powered by automotive sales, which rose 0.7%, while non-auto sales were nearly stagnant. Manufacturing output declined by 0.1%, its first contraction since September 2004. Capacity utilisation in the manufacturing sector actually declined.

Other recently released figures suggest that business sales dropped steeply in February, pushing business inventories up by 0.5%. Correcting this build up in stocks will force firms to restrain production yet further in the coming months. Latest survey evidence for New York State, a bellwether for the rest of the nation, showed a substantial weakening in industrial activity during April.

These disappointing indicators sit uncomfortably alongside other data releases that suggest that US inflationary pressures are heating up. Not only are energy prices very high, but also core inflation (which excludes the direct impact of food and energy price changes) has been gradually accelerating and is now running at 2.3% (up from just over 1% a year ago). During the early stages of the economic recovery consumers would not have tolerated such price increases. But anecdotal evidence suggests that firms in some regions of the US are now encountering less price resistance than in the recent past and have been able to pass increasing costs on to consumers. And costs for firms are certainly rising--producer prices (excluding food and energy) are increasing at their fastest pace in a decade, with energy costs adding an further burden.

One reason why prices are accelerating even as demand is slowing is that the price increases are emanating from overseas. Energy prices are, of course, dictated by demand and supply in global oil markets--and supply is currently very tight as China’s appetite for energy soars. Meanwhile, the weakness of the US dollar has clearly been an important factor in driving up prices for other kinds of goods and raw materials. As the purchasing power of the US currency declines, imported goods become ever more expensive. Import prices were up 1.5% on the month in March, putting them a whopping 7% up on a year ago.

Can Uncle Sam do anything about this? The oil market is largely out of its control--Chinese demand seems set to keep on rising, and efforts to bring new oil supplies to market take years, not months. And the weakness of the dollar is being driven by some significant structural factors. America runs a huge and growing trade deficit with the rest of the world, the funding of which requires it to attract substantial capital inflows from foreign investors. Over the past few years persuading foreign investors to keep the dollars rolling in has become harder and harder--and a falling currency has been the result. While the dollar is currently enjoying a mini-revival, such rallies tend to be short-lived and it is hard to see the dollar doing anything other than falling further over the coming year. The trade deficit hit another record in February, reaching US$61bn, suggesting that the US’s need for foreign funding remains unabated.

Still, even if the oil market is outside US control, and the dollar weakness has a deep-rooted cause, policymakers are not exactly unarmed in the fight against inflation. The US Federal Reserve (the central bank) has been steadily tightening monetary policy since June 2004. Initially this was aimed at merely normalising interest rates after a period of exceptionally loose monetary policy. But more recently the Fed has had at least half an eye on the inflation data, and in the months ahead some analysts fear the Fed will up the pace of rate increases if price pressures continue to grow. Others, however, hope that the Fed will switch its attention back to the real economy and put interest rates on hold. Indeed, futures markets are factoring in a pause in policy tightening in the second half of the year.

The stockmarket has been particularly sensitive to this economic environment. The Dow Jones industrial average plummeted to its lowest level since early November during the week of April 11th. Although a slight recovery is in prospect following the sell-off, the index could fall below the 10,000 barrier if economic conditions deteriorate. Investors suddenly see the US recovery in jeopardy, very much in contrast with the confident picture painted by the Federal Reserve following its recent rate increases.

The sudden deterioration in Wall Street’s sentiment and the fears about the US economy represent a return to reality after a period of surprising buoyancy. The Economist Intelligence Unit’s own forecasts have long reflected a sober view of the US’s prospects. The economy is by no means heading for the buffers--we expect GDP growth to average 3.3% in 2005 and 2.9% in 2006. But this is far from the heady pace of growth (4.4%) experienced last year. Policy stimulus is being withdrawn--interest rates are rising and the room for further fiscal easing is limited. Consumers are highly indebted, house prices are stabilising (and may fall in some areas) and businesses are reluctant to increase hiring substantially. These retarding factors have been clear for some time, but only recently are financial-market participants taking them seriously.

Looking at the details of our US macroeconomic forecast, there seems to be potential for more financial-market upset over the coming months. Our oil price forecast suggests little relief over the coming year, as oil-market participants are demanding an ever-higher risk premium in the face of limited global spare production capacity. We expect Brent dated oil prices to reach an average of US$46/b in 2005 and US$40/b in 2006. This equates to a West Texas Intermediate price of US$50/b this year and US$43/b in 2006--figures that will surely worry both the equity and bond markets.

The US budget deficit will also remain a prime source of concern. The Bush administration projects that the deficit will fall to US$233bn (1.5% of GDP) in fiscal year 2008/09 (October-September). But this is based on a severe squeeze in discretionary spending that is unlikely to take place. The Economist Intelligence Unit expects continued large budget deficits, averaging 4% of GDP per year in 2005/06 to 2008/09.

This large budget deficit means that America will continue to require substantial inflows of foreign funds over the coming years. This, in turn, is likely to put yet further downward pressure on the US dollar. Although the dollar exchange rate against the yen and the euro has been stronger than expected in recent weeks, we continue to expect the dollar to weaken during the course of 2005 in view of the current-account and fiscal deficits. We forecast that the unit will average US$1.35:€1 and ¥103:US$1 in 2005 and US$1.40:€1 and ¥94:US$1 in 2006. The risk of an even sharper US dollar correction remains high.

Despite this laundry list of economic problems facing the US, investors should not become too pessimistic. None of this suggests that the economy will perform very poorly in the months or year ahead. A recession, or even a substantial economic slowdown, still remains unlikely. But an "average performance" is in prospect, with the US economy expanding by around 3% a year as some of these difficult economic issues are gradually addressed.

The problem is, financial-market participants are clearly hoping for more--a return, perhaps, to the heady days of the late 1990s with rapid growth and very low inflation. The recent financial-market gyrations are, perhaps, a sign that a more realistic assessment of US prospects is gaining currency with investors.

But what if our laundry list of problems does, in fact, trigger a sharp economic slowdown even as oil prices and a weak dollar drive inflation ever higher? Rising prices and a no-growth economy? A return to the dreaded "stagflation" of the 1970s? You heard it here first.

While the dollar is currently enjoying a mini-revival, such rallies tend to be short-lived and it is hard to see the dollar doing anything other than falling further over the coming year.

That "mini revival" has been brought to us coutesy of a number of interest rate hikes. It is not sustainable and ultimately a very expensive strategy for supporting the dollar.

The one thing that is not mentioned in this article is the trade deficit which is currently an even bigger monkey then the budget deficit. Every month we need to borrow $60,000,000,000.00+ new dollars to finance our net monthly import of goods and services, and that number continues to grow.

So now we're to believe that we have inflation and unemployment worse than the double digit numbers of the Carter years.

Am I the only one here that is aware that we do not have 20 inflation and 15 percent unemployment? Ok, maybe we agree that it's not quite that bad, but for me to believe that it will be that bad say, by 2:00pm today, is going to take more proof than simply taking Dan Rather, Jason Blair, and Economist's word for it.

A return to the dreaded "stagflation" of the 1970s? You heard it here first.

Looks like the alarmists have come up for air.

We learned our lessons of the 70's and early 80's and have been very successful at controlling inflation since. GDP growth of 4.4% in 2004 and projected 3.3% growth in 2005, thanks to the 2003 tax cuts, make our current situation nothing like what occurred in the 1970's. Stagflation will require a lot more gloom to create than what we are now experiencing.

Our current problems are more about policy than economics. Government gridlock has stalled Social Security reform, energy policy and making Bush's tax cuts permanent. Sarbanes-Oxley has had an unintended negative impact on business activity and the threat of tariffs and a subsequent trade war with China is also weighing on the economy.

I think the EIU may be mistaking deceleration and decline.

is going to take more proof

This is one of those things; like arguing that getting shot hurts, that we should not want to see proven too overtly.

Is unemployment better or worse? No one can say for certain since we are only provided with an "unemployment rate", and that tells us virtually nothing about the job inventory, real unemployment, or the quality of jobs. What we really need is a comparative count of people available for work between the ages of 18-65 and a similar inventory of job, so that we can look at what has been actually happening over the last 10-20 years. Looking at an unemployment rate is like looking at a magnetic compass and guessing at your position when you are not even sure which ocean you are in. It just doesn't provide enough information to get us to where we want to be.

As for inflation. Be advised that food and energy are ordinarilly excluded from the basket of goods used to measure it; nor, are housing costs calculated as we would expect them to be. If Gasoline, food, and housing pricing have been climbing as fast as they appear to be, if the dollar has been dropping as fast as it has been, then the real inflation rate could be enormous. The price of housing and gasoline has nearly doubled in less then five years.

The Bernanke Electric Mayhem Money Printing Machine and all its ramifications is the unseen hand behind the PPI. This is not anything that can be called transitory or irrelevant because of violent price movements such as oil. In a nutshell, it is the hidden hand of monetary liquidity that was introduced unconventionally into the marketplace and can not be recovered.

This brand of monetary liquidity was created out of thin air and seemingly fell like manna from the heavens. It poured into the world monetary system with the speed of bank wires from Japan to the New York Federal Reserve as the former intervened in the international currency markets. This is the electronic character of Bernanke’s money printing press.

The mechanics of this type of international monetary liquidity was produced by the purchase of US Treasury instruments all across the maturity spectrum by the New York Fed as soon as each bank wire was received from the Bank of Japan. This liquidity blast was mechanically produced by the management of the Japanese Float account, namely the New York Federal Reserve.

The New York Federal Reserve Bank then bought US Treasury instruments in a 24 hour operation as fast as dollars were produced by the Japanese intervention in the marketplace to maintain an artificial level of the Yen in international markets.

This non-traditional method of expanding international monetary liquidity CANNOT BE DRAINED from the system because you can buy huge amounts of US Treasuries which you can not sell without cremating the bond market. This is true because bonds are always being produced so the supply is theoretically unlimited but demand is not.

This colossal injection of the largest amount of international monetary liquidity that has ever occurred in the shortest period of time is the UNSEEN HAND that will drive inflation up as the US economy rolls over and moves sideways at a high level.

The reason the US economy will not crater is the fiscal stimulation caused by two wars and the monetary stimulation that was created by the above mentioned non-traditional methods.

Corporate profits will, however, crater because costs are going up, money costs more and productivity is headed lower, with consumers less optimistic due to the increased cost of everything including gas.

The decline in corporate and personal tax revenues, with no meaningful decline in expenses, will drive the US Federal budget much higher. The increased size of the US Federal Budget Deficit will cause the US Current Account to rise, making it larger as a percent of GDP. This is how it is factored into dollar valuation.

So - what to invest in?/i For me it is real estate. In southern Oregon we have seen the prices go up over 30% in some neighborhoods. Last year I bought a rental house for $115K, 3 bd, 2 ba 1400 sq. ft. This year it is worth $150K. We are finally catching up to the rest of the country, but many investors in the west coast and some from Texas are talking about southern Oregon real estate prices. Real Estate in most areas is really safe, but long term, just like stocks.

A recession, or even a substantial economic slowdown, still remains unlikely. But an "average performance" is in prospect, with the US economy expanding by around 3% a year as some of these difficult economic issues are gradually addressed.

Sounds like everything is pretty good but the pessimistic disclaimer is for CYA purposes.

I agree that the government is measuring the wrong things and that those erroneous, perhaps partial is a better term, figures are often used for decision making purposes. Even if the smart investors don't follow those figures the figures still serve to affect consumer and investor confidence.

Your description of the unemployment numbers is especially important but I don't know how we could do it correctly. You could take an inventory of the want ads and employment services' available positions but that has considerable overlap and still doesn't cover those jobs and applicants who are listed in neither.

The government inflation figures are, as you say, near worthless because of what they exclude. That can be corrected. I don't know why it is not, unless they consider those prices to be too volatile. I suspect you do know. What is the reason?

The mechanics of this type of international monetary liquidity was produced by the purchase of US Treasury instruments all across the maturity spectrum by the New York Fed as soon as each bank wire was received from the Bank of Japan. This liquidity blast was mechanically produced by the management of the Japanese Float account, namely the New York Federal Reserve.
The New York Federal Reserve Bank then bought US Treasury instruments in a 24 hour operation as fast as dollars were produced by the Japanese intervention in the marketplace to maintain an artificial level of the Yen in international markets.
This non-traditional method of expanding international monetary liquidity CANNOT BE DRAINED from the system because you can buy huge amounts of US Treasuries which you can not sell without cremating the bond market. This is true because bonds are always being produced so the supply is theoretically unlimited but demand is not.
This colossal injection of the largest amount of international monetary liquidity that has ever occurred in the shortest period of time is the UNSEEN HAND that will drive inflation up as the US economy rolls over and moves sideways at a high level.

Any factual reference source for these statements? And when did these events occur?

A great deal of present dollar strength was in the unwinding of down under carry trades and short covering. Both of these only impact the USD for short periods of time. Then there is the clear desire on the part of many central banks to hedge short the USD against their long US treasury instrument positions. What you can't sell, you can hedge.

Add to that a float of the Chinese currency and China is relieved of having to buy US dollars to prevent the upward movement of its currency. This is clearly dollar negative as well as disastrously TIC negative.

we have this discussion on many threads - I always tell people who scream that if we do anything about china, prices of chinese goods will rise - they will, but how much of your monthly budget is spent on that stuff? if a shirt rises from $10 to $13, how many are you buying in any case? how many DVD players are you buying? in the meantime, most of my monthly budget goes to housing, taxes, energy, food, consumer non-durables, insurance, transportation, services (cell phone, cable TV), and entertainment (restaurants, etc).

Comment by Paul Volcker,

On the present trajectory, the deficits and imbalances will increase. At some point, the sense of confidence in capital markets that today so benignly supports the flow of funds to the United States and the growing world economy could fade. Then some event, or combination of events, could come along to disturb markets, with damaging volatility in both exchange markets and interest rates. We had a taste of that in the stagflation of the 1970s -- a volatile and depressed dollar, inflationary pressures, a sudden increase in interest rates and a couple of big recessions.

http://www.washingtonpost.com/wp-dyn/articles/A38725-2005Apr8.html

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