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The Risk Of Stagflation In The US
Malaysia Perspective | 15 September 2011
By: Andy Chiok
Articles (1) Profile

While Keynesian theory has an answer for depressions, no one has a clue on how to address stagflations. Monetary policy will not help as stagflation is the combination of the two evils in economics – inflation (or rising interest rates) and dampened demand. Tight monetary policy will kill off whatever depressed demand that remains, while a loose monetary policy will further fuel inflation.

This writer has written, sometime back, about a tight spot called a liquidity trap that the US has found itself in. This happens when interest rates are kept artificially low and yet demand is not being stimulated. Even Bernanke has expressed the desire for a ‘preferred’ level of interest rates higher than the ‘close-to-nothing’ of today as a certain amount of inflationary pressure must be present in a healthy economy. In its current state, consumers in the US still prefer to stash money away in banks no matter how low the rate of interest. This paradox of thrift will result in lower revenue, and thus, lower margins for companies, ultimately leading to companies laying off employees to trim cost, and the cycle goes on. The only reason why this latter scenario has yet to be observed is due to the fact that more than half of the revenue of these multinational corporations in the US is contributed by Asia and perhaps the countries of Latin America.

Things have yet to improve today. While the rest of the world is raising rates to combat mild inflationary pressures – a ‘good’ problem, really – the US economy is still in the doldrums. Even Jean-Claude Trichet, President of the European Central Bank (ECB), has raised rates twice – notwithstanding issues with the sovereign debts of peripheral nations. As a net importer of goods and services, the US is now finding itself having to cope with rising food and fuel prices. Over the last 12 months up to July 2011, the US CPI all items index has increased 3.6 percent before seasonal adjustment.

To complicate matters, sustainability of the 0.8% increase in consumer spending in July, which drives two-thirds of the US economy, is still a question. This was the largest increase in five months. Consumer confidence has fallen to the lowest level since 2009 adding to concerns that weak employment and falling housing prices will deter consumers from spending. The Thomson Reuters/University of Michigan preliminary index of consumer sentiment decreased to 54.9 in early August from 63.7 at the end of July.

And what about industrial production? Industrial production has increased 0.2 percent in June after having edged down 0.1 percent in May. For the second quarter as a whole, total industrial production has increased at an annual rate of 0.8 percent. While industrial production growth over the previous month was marginally lower than expected, New York’s manufacturing was still in the red after an unexpected deterioration the month before. The New York Fed manufacturing index has inched up to -3.8 after having dropped to -7.8 in June, well below the expected 12.5.

Funny Money & Politics
It has only been nine months ago when the number one concern of the Fed has been the danger of the economy slipping into a deflation. Then a funny thing happened: prices of commodities and fuel rose to very high levels. Imported inflation was also starting to fuel inflation. This was despite falling wages and still softer financial and real estate markets at home.

Then there was politics. The way the US economy is run, there is an assumption that the federal government can borrow ever increasing percentages of the country’s GDP and spend ever increasing percentages of GDP on interest payments, while interest rates remain low. This has resulted in a current account deficit of US$119 billion in the first quarter of 2011 and a public debt of US$14.46 trillion as at 29 June – approximately 98.6 percent of 2010’s GDP of US$14.66 trillion. It does not take a genius to see that this is not sustainable.

The other fact is that the federal government’s revenue is largely built on payroll taxes. This totaled approximately US$907 billion (42 percent of approximately US$2.16 trillion) in FY2010. “Unfortunately, one in six Americans cannot get as much work as they want,” said Ashley Norton, Director and Head of Retail Sales, Southeast Asia at BlackRock. “Until we solve that problem, we are going to have a deficit problem.”

Meanwhile, high inflation and a falling sterling pound have made it difficult for the UK government to sell gilts. This could be a US problem very soon. From a high of 82.595 a year ago (22 July 2010), the Dollar Index Spot (DXY:IND) has fallen some 10.2 percent to close at 74.201, yielding new low to date.

Norton observed that the Fed has been engaging in unprecedentedly aggressive behaviour, specifically by sharply increasing the size of its balance sheet and increasing the amount of money in circulation for the past few years. From the mid-90s until 2008, the Fed’s balance sheet has grown consistently – although relatively smoothly – and had reached something under US$900 billion in early 2008. From there, it has exploded and stands at about US$2.7 trillion today.

In addition to funny money floating around, labour costs in China and India are starting to increase significantly. “These areas of the world have put a damper on our labour costs, producing cheap manufactured goods and cheap services that [have] helped kept prices down for the developed consumer,” says Norton. “Now, wages in those countries are rocketing ahead at double-digit rates, and we don’t see that changing anytime soon.”

It is an understatement to say that stagflation is no good for equities. The point being missed is that the consequences of a stagflation today will be doubly bad, given the high expectations for the US market to perform. Even real assets will be hit hard as stagflation will necessarily mean lower demand for both commodities and real estate, safe except gold. Norton, however, does not share the sentiment.

“On one hand, we have structural challenges in the developed world from high levels of indebtedness, a depressed housing market and high unemployment. On the other hand, cheap services, cheap goods and low energy prices are unlikely to prevail going forward. As a result, to preserve wealth in real terms, we believe we need to own some real assets, hard assets, commodities, commodity producers and the stocks of companies that have real businesses.”

You call the shots…


The US Dollar Index (USDX) is an index (or measure) of the value of the US Dollar relative to a basket of foreign currencies.

Currently a communications specialist, Andy has also spent 15 years in banking & finance dealing with derivatives, FX, Equities, and Wealth Management. He is a Certified Financial Planner (CFP) and holds an MBA from South Australia. Andrew also has a professional diploma in banking & finance from the Institute of Banking & Finance.

Please click here for more information about this author.


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