Re: Roach-Stagflation


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(an email exchange)

A few of things:

First, the rising wages in the 70’s led to bracket creep that put the budget in surplus in 1979 and resulted in a severe recession soon after.

This time around it is unlikely the inflation takes much of a dent out of the deficit so it’s more likely demand will be sustained to support prices. And, at least so far, Congress has acted to sustain demand and support prices with the latest fiscal package and more seemingly on the way.

Second, last time around the oil producers for the most part didn’t spend all that much of their new found revenues and thereby drained demand from the US economy. This time around they seem to be spending on infrastructure at a rate sufficient to drive our exports and keep gdp muddling through.

Third, I recall it was maybe the deregulation of nat gas that freed up a cheap substitute for electric utilities and unleashed a massive supply response as nat gas was substituted for crude at the elect power producers. After 1980 opec cut production by something like 15 million bpd to hold prices above 30 until they could cut no more without capping all their wells and the price tumbled to about 10 where it stood for a long time. This time around that kind of excess supply is nowhere in sight.

>
>   On Thu, Jun 12, 2008 at 11:59 PM, Russell wrote:
>
>   Stephan Roach is chairman of Morgan Stanley Asia, and pens
>   this missive for the FT, in which he contextualizes why the
>   Fed’s options are limited:
>
>   ”Fears of 1970s-style stagflation are back in the air. Global
>   bond markets are growing ever more nervous over this possibility,
>   and US and European central bankers are talking increasingly
>   tough about the perils of mounting inflation.
>
>   Yet today’s stagflation risks are very different from those that
>   wreaked such havoc 35 years ago. Unlike in that earlier period,
>   wages in the developed economies have been delinked from prices.
>   That all but eliminates the automatic indexation features of the
>   once dreaded wage-price spiral – perhaps the most insidious
>   feature of the “great inflation” of the 1970s. Moreover, as the
>   stunning surge of the US unemployment rate in May suggests,
>   slowing economic growth in the industrial economies is likely to
>   open up further slack in labour markets, thereby putting downward
>   cyclical pressure on wages over the next couple of years.
>
>   But there is a new threat to global inflation that was not present
>   in the 1970s. It is arising from the developing world, especially in
>   Asia, where price pressures are lurching out of control. For
>   developing Asia as a whole, consumer price index inflation hit 7.5
>   per cent in April 2008, close to a 9½-year high and more than double
>   the 3.6 per cent pace of a year ago. Sure, a good portion of the recent
>   acceleration in pricing is a result of food and energy – critically
>   important components of household budgets in poorer countries and
>   yet items that many analysts mistakenly remove to get a cleaner read
>   on underlying inflation. But even the residual, or “core”, inflation rate
>   in developing Asia surged to 3.8 per cent in April, more than double
>   the 1.8 per cent pace of a year ago…”
>
>

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Stagflation

Yes, the below analysis has also been the Fed’s position, up until this week’s speeches.

It’s been about a crude/food/$ negative supply shock, supported by Saudis/Russians acting as swing producer and biofuels linking crude prices to food prices.

The fed has called the price hikes relative value stories that they don’t want turning into an inflation story. They feel they have room to cut rates as long as expectations stay well anchored, which includes wage demands but other things as well.

Yellen the dove, along with the hawks, now saying inflation expectations are showing signs of elevating, and saying energy costs are being passed through to core inflation is a departure from previous Fed rhetoric and may signal they are at or near their limits regarding ff cuts (data dependent, of course).

Also, Bernanke pushing Congress and the President to add to the deficit could also be a sign he is reaching his inflation tolerance regarding lowering the FF rate. The mainstream belief is that inflation is a function of monetary policy, not fiscal policy.

Now with the ECB perhaps throwing in the towel on inflation as well, look at how the commodities are responding. ‘Cost push inflation’ is ripping, and the perception is the CB’s around the world will act to sustain demand, including pushing for larger fiscal deficits.

Difficult to explain why so many have stagflation on the brain It is difficult to explain why so many folks still have stagflation or inflation on the brain just because wheat prices have soared to new highs. We have to distinguish between relative and absolute pricing. Not only that, but unlike the 1970s, the current ‘inflation’ backdrop is much more narrowly confined. The key is the labor market. And here we have a 4-quarter growth rate in unit labor costs of a mere 1% in 4Q (a three-year low), which compares to 4% heading into the 2001 downturn. In other words, as far as the labor market is concerned, inflation is less of a threat to the economy than it was at this same stage of the cycle seven years ago. In fact, heading into the 1990 recession, the trend in ULC was also 4% – the Fed sliced the funds rate from almost 10% to 3% that cycle, for crying out loud. In fact, scouring more than 50 years’ worth of data, at no time in the past has the year-to-year trend in unit labor costs been as low as it is today heading into an official recession. Make no mistake, deflation is going to emerge as the next major macro theme.


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