Monday, May 14, 2018

The Return Of Horror Stagflation 1970s Style

One of the worst possible outcomes for the U.S. economy, and ultimately for investors, is stagflation. Of course, if you weren’t around in the 60-70’s, there is a reasonably high probability you are not even sure what “stagflation” is.

Here is the technical definition: “stagflation – persistent high inflation combined with high unemployment and stagnant demand in a country’s economy.” How can that happen? Exactly in the way you are witnessing now.

While the current Administration is keen on equalizing trade through tariffs, trade deals, and trade deficit reduction, they have also embarked on a deficit expanding spending spree which has deleterious long-term effects on economic growth. At the same time, the administration is attacking our major trading partners, particularly China, leading to a push to shift away from the U.S. dollar as a reserve currency.

What does all that mean? Here is the problem with the current trajectory.

1. A weaker dollar leads to higher commodity prices creating cost-push inflation.
2. As fears of inflation infiltrate the markets, interest rates increase which raises borrowing costs.
3. As the dollar weakens, commodity prices rise increasing input cost to manufactures.
4. Higher input costs, borrowing costs, and weaker profits ultimately force corporations to suppress wage growth to protect profits.
5. As wage growth is suppressed, particularly with a heavily indebted consumer, demand falls as higher costs, both product and borrowing costs, cannot be compensated for.
6. As demand falls, companies react by reducing the highest costs to their bottom lines: wages and employment.
7. As profits come under pressure, stock prices fall which negatively impacts the “wealth effect” further curtailing consumptive demand.
8. As the economy slumps into recession, unemployment rise sharply, demand falls, and interest rates decline sharply.

As I discussed just recently, the bottom 80% of U.S. households are heavily indebted with no wage growth to offset the rising costs in “non-discretionary” spending requirements of rent, utilities, food and healthcare and debt payments. However, as the dollar weakens, the input costs to manufacturers rise leading to concerns of inflationary pressures which pushes interest rates higher.

The biggest risk to the markets, and investors, is both the current Administrations trade policies, particularly as it relates to China, and the reduction of the Federal Reserve’s balance sheet.

Combined, these two represent the largest buyers of U.S. Treasuries which is most inopportune at a time where the fiscal deficit is set to swell creating a surge in U.S. debt issuance. (The chart below is the annual rate of change of foreign holdings of U.S. Treasuries versus the annual change in interest rates.)
Furthermore, this is all occurring at a time when global liquidity is being withdrawn. “The removal of global policy stimulus has naturally come about as the world economy finally managed a couple of quarters of synchronised growth in 2017. But our view is that this growth is tenuous and very late-cycle, particularly in China and the US, as the credit cycle has already turned. And the next challenges for markets are just around the corner.”

While much of the mainstream media continues to promote expectations of a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then population, wage, and consumer debt growth become key inputs into that equation.

Unfortunately, with real wage growth stagnant for the bottom 80%, demographics running in reverse, and consumers extremely leveraged, a sustained surge in economic growth to offset higher interest rates becomes unlikely.

So, to summarize, we have a depreciating dollar policy from the White House, which is inflationary, with the Fed and foreign purchasers of our bonds not keeping pace with burgeoning deficits. With inflation, not generated by economic growth but by a weak dollar instead, pushes interest rates higher, the combination is a deadly one-two punch for the economy. This is an outcome to which the market is currently ill-prepared for.

Until the 1970s, many economists believed that there was a stable inverse relationship between inflation and unemployment. They believed that inflation was tolerable because it meant the economy was growing and unemployment would be low.

Their general belief was that an increase in the demand for goods would drive up prices, which in turn would encourage firms to expand and hire additional employees. This would then create additional demand throughout the economy.

According to this theory, if the economy slowed, unemployment would rise, but inflation would fall. Therefore, to promote economic growth, a country's central bank could increase the money supply to drive up demand and prices without being terribly concerned about inflation.

According to this theory, the growth in money supply would increase employment and promote economic growth. These beliefs were based on the Keynesian school of economic thought, named after twentieth-century British economist John Maynard Keynes.

In the 1970s, Keynesian economists had to reconsider their core beliefs as the U.S. and other industrialized countries entered a period of stagflation. Stagflation is defined as slow economic growth occurring simultaneously with high rates of inflation. Eventual reversal in the Federal Reserve's monetary policy (which exacerbated the problem) as prescribed by Milton Friedman had eventually brought the U.S. out of the stagflation cycle.

Stagflation and Its Causes: Can Stagflation Happen Now?

Stagflation is a combination of stagnant economic growth, high unemployment, and high inflation. It's an unnatural situation because inflation is not supposed to occur in a weak economy. Consumer demand drops enough to keep prices from rising. Slow growth in a normal market economy prevents inflation.

Stagflation occurs when the government or central banks expand the money supply at the same time they constrain supply. The most common culprit is when the government prints currency. It can also occur when central bank monetary policies create credit. Both increase the money supply. That creates the inflation.

At the same time, other policies slow growth. That happens if the government increases taxes. It can also occur when the central bank raises interest rates. Both prevent companies from producing more. When conflicting expansionary and contractionary policies occur, it can slow growth while creating inflation. That's stagflation.

Stagflation in the United States occurred during the 1970s. The federal government manipulated its currency to spur economic growth. At the same time, it restricted supply with wage-price controls. In 2004, Zimbabwe's policies caused stagflation. The government printed so much money it went beyond stagflation and turned into hyperinflation.

Stagflation got its name during the 1973 - 1975 recession. There were five quarters when gross domestic product was negative.

GDP Growth  Q1       Q2       Q3       Q4

1973    1.2%   4.6%    -2.2%   3.8%
1974    -3.3%   1.1%    -3.8%   -1.6%
1975    -4.7%   3.1%    6.8%    5.5%

Unemployment peaked at 9 percent in May 1975, two months after the recession ended. Inflation tripled in 1973, rising from 3.4 to 9.6 percent. It remained between 10 to 12 percent from February 1974 through April 1975. By looking at the nation’s inflation rate by year, you can get a history of the annual percentage change in prices over a span of a business cycle.

How did this happen? Many experts blame the 1973 oil embargo. That's when OPEC cut its oil exports to the United States. Prices quadrupled, triggering inflation in oil. But that alone wasn't enough to cause stagflation. Instead, it was a combination of fiscal and monetary policy that created it.

It started with a mild recession in 1970. GDP was negative for three quarters. Unemployment rose to 6.1 percent. President Richard Nixon was running for re-election. He wanted to boost growth without triggering inflation. 

On August 15, 1971, he announced three fiscal policies. They got him re-elected. They also sowed the seeds for stagflation. A video of Nixon's speech shows the announcement of significant economic policy changes such as the decision to end the Bretton Woods international monetary system.

First, Nixon instituted a 90-day freeze on all wages and prices. He set up a Pay Board and Price Commission to approve any increases after the 90 days. Conveniently, it would control prices until after the 1972 presidential campaign. That's how he planned to control inflation.

Second, Nixon imposed a 10 percent tariff on imports. He intended to lower the balance of trade and protect domestic industries. Instead, he raised import prices.

Third, he removed the United States from the gold standard. That had kept the dollar's value tied to a fixed amount of gold since the 1944 Bretton Woods Agreement. Most countries agreed to peg the value of their currencies to either the price of gold or the U.S. dollar. That had turned the dollar into a global currency.

The crisis occurred when the United Kingdom tried to redeem $3 billion for gold. The United States didn't have that much gold in its reserves at Fort Knox. So Nixon stopped redeeming dollars for gold. That sent the price of the precious metal skyrocketing and the value of the dollar plummeting. That sent import prices up even more.

These last two policies raised import prices, which slowed growth. Then growth slowed even more because U.S. companies couldn't raise prices to remain profitable. Since they couldn't lower wages either, the only way to reduce costs was to lay off workers. That increased unemployment. Unemployment reduces consumer demand and slows economic growth. In other words, Nixon's three attempts to boost growth and control inflation had the opposite effect.

The Federal Reserve's attempts to fight stagflation only worsened it. Between 1971 and 1978, it raised the fed funds rate to fight inflation, then lowered it to fight recession. This "stop-go" monetary policy confused businesses. They kept prices high, even when the Fed lowered rates. That sent inflation up to 13.3 percent by 1979. 

Federal Reserve Chair Paul Volcker ended stagflation by raising the rate to 20 percent in 1980. But it was at a great cost. It created the 1980-82 recession.

In 2011, people became concerned about stagflation again. They worried that the Fed's expansive monetary policies, used to rescue the economy from the 2008 financial crisis, would cause inflation. At the same time, Congress approved an expansive fiscal policy. It included the economic stimulus package and record levels of deficit spending. Meanwhile, the economy was only growing 1 to 2 percent. People warned of the risk of stagflation if inflation worsened and the economy didn't improve.

This massive increase in global liquidity prevented deflation, a far greater risk. The Fed won't allow inflation to go beyond its inflation target of 2 percent for the core inflation rate. If inflation rose above that target, the Fed would reverse course and institute constrictive monetary policy.

The unusual conditions that created stagflation in the 1970s are unlikely to reoccur. First, the Fed no longer practices stop-go monetary policies. Instead, it commits to a consistent direction. Second, the removal of the dollar from the gold standard was a once-in-a-lifetime event. Third, the wage-price controls that constrained supply wouldn't even be considered today.