April 2022 Insights

Get Ready for A Blast from the Past: Stagflation

We are likely to hear the word “stagflation” more and more in the coming months, which should be cause for concern. A portmanteau of “stagnation” and “inflation”, stagflation is a situation in which prices don’t stop rising in a sluggish or shrinking economy. Put simply, it is the worst of both worlds. The term was first coined by the former British Chancellor of the Exchequer Ian McLeod in 1965 and became popularised during the oil shocks of the early and late 1970s. It was then largely forgotten for the best part of the next 40 years but is now making a big comeback.

US Leading the Way

The United States is already almost there, having just reported a 1.4% annualized decline in economic growth for the first quarter of 2022 as well as its worst inflation rate since the second quarter of 1981, when the country was finally emerging from the stagflation of the ´70s. Once again, prices are surging – or put differently, the value of money is crumbling – at the same time that the economy appears to be stagnating.

There are a whole bunch of factors that have contributed to the stagnating economy, including the Federal Reserve’s long-awaited decision to hike interest rates in March to counteract high inflation; the withdrawal of certain stimulus programs; the ongoing (and arguably worsening) supply chain crisis; and the economic fallout of Russia’s invasion of Ukraine and the West’s ratcheting sanctions against Russia, which is threatening to create a global energy and food crisis.
Stagflation expectations in the US are now at their highest since 2009, when the world economy was still being roiled by the global financial crisis. According to the latest edition of Bank of America’s Fund Manager Survey, investors are fretting that the current economic and geopolitical conditions could give rise to a perfect storm. In March, 62% of the survey’s respondents said they expect the U.S. economy to see stagflation, a number that has more than doubled from February’s reading of 30%.

Here in the UK, we also appear to be on the same path. Consumer price inflation rocketed to 7% in March, well above the Bank of England’s most recent forecast of 6%. It’s the highest level for three decades. Rather than being “transitory”, as the BoE and myriad other central banks repeatedly assured financial markets last year, it seems that high inflation is becoming a long-term feature of the post-lockdown economy.

Just as worrisome, economic activity in the UK is beginning to slow. The British economy barely expanded at all in February. After growing 0.8% in January, GDP dropped to just 0.1 per cent a month later. Surging energy prices, climbing interest rates and the biggest rise in the tax burden on consumers and businesses since the 1940s have all taken a heavy toll on economic activity. Here’s how Germany’s foremost financial publication, Handelsblatt, put it:

“Britain’s economic dilemma can be summed up in three figures: inflation 7%, unemployment 3.8%, growth 0.1%. For economists this is a clear sign of impending stagflation and a historic shock to Britons’ real incomes.”

History Rhyming in Germany (and Europe)?

Germany is hardly in a position to talk, having reported consumer price inflation of 7.3% in March as well as annual producer price inflation of 30%, the highest level since the country’s Federal Statistics Office began collecting data 73 years ago. As Richard Werner, the German economist who first coined the term “quantitative easing”, noted in a tweet on April 20, the anniversary of Adolf Hitler’s birthday, Germany can “celebrate its highest inflation rate… since this day was a national holiday and Hitler was leader. The central bank-induced (hyper)inflation of the early 1920s & the social dislocation it caused were key factors in his rise to power.”

Given the German people’s resulting (and perfectly understandable) fear of high inflation, history could once again rhyme as surging wholesale and consumer prices threaten to unleash political repercussions both in Germany and in the EU at large. This is something that is certainly worth keeping an eye on, especially given: a) the ECB faces even bigger risks and challenges trying to tame inflation than most other large central banks; and b) how much of Europe’s galloping inflation is due to the rising costs of energy (which we discussed in our last newsletter.

With the EU mulling imposing a full embargo on Russian imports of oil and perhaps even natural gas, energy prices in Europe could still rise much higher. So serious has the situation become that companies and unions in Germany recently joined forces in opposition to the proposed embargo, reminding authorities that Germany depends on Russia for roughly one third of all its energy consumption. For its part, Germany’s central bank, the Bundesbank, has warned that an embargo on Russian gas would cost Germany’s economy a staggering €180 billion in lost output this year as the price of energy products would soar to unimaginable levels and shock the economy into one of the deepest downturns in years:

“In the severe crisis scenario, real GDP in the current year would fall by almost 2% compared to 2021. In addition, the inflation rate would be significantly higher for a longer period of time.”

Inflation is already surging across Europe. Across the EU as a whole consumer price inflation ranged from 4.5% in Malta and France to 15.7% in Lithuania. It has reached 6.5% in Italy, 9.8% in Spain and 9.7% in the Netherlands. At the same time, economic activity in the region is slowing rapidly, in large part as a direct result of the inflationary pressures. The IMF has already slashed its 2022 growth forecasts for advanced EU economies to a still exceptionally optimistic 3%, from 4% in January, primarily due to the fallout of the Russia-Ukraine conflict.

Lockdowns in China

On the other side of the Eurasian landmass, Beijing’s increasingly desperate attempts to contain the spread of COVID-19 by imposing its most extensive COVID-19 lockdowns threatens to trigger a dramatic fall in both global demand for commodities and global supply of consumer goods. As Omicron rips through the country, 44 Chinese cities comprising two-fifths of the world’s second biggest economy are currently under lockdown. They include China’s biggest city, Shanghai, which is home to the world’s largest container port and has been shuttered since March 18.

This is already setting off reverberations across global supply chains, which are almost certain to grow over the coming weeks and months. A fifth of the world’s containerships are currently stuck in congestion, with 30% of them waylaid off the coast of China. Victor Meyer, COO of the risk intelligence provider Supply Wisdom, believes it will take months for supply chains to return to normal and expects U.S. ports to begin suffering disruptions soon.

“The next effect will likely be felt in the U.S. West Coast’s ports of Los Angeles and Long Beach as the pent-up demand reaches them,” he said.
At the same time, China’s lockdowns, which could soon be extended to the capital, Beijing, are also crippling consumer demand in the world’s second largest economy, which is already in the grip of a massive real estate crisis. On the one hand, this is likely to reduce global energy demand and hence prices, at least in the short term, which is not a bad thing. But the prolonged lockdowns are also fueling fears that the resulting supply chain crisis could trigger even worse inflation that will hit demand even harder.

If the Chinese lockdowns drag on, we could end up seeing continuous waves of supply dysfunction, with dangerous impacts on the global economy. And that is before even considering the potential impact of many of the world’s biggest central banks simultaneously calling time on over a decade of ultra-loose monetary policy, in a (most likely vain) attempt to bring under control the rampant inflation that their own rampant money printing was instrumental in stoking.

Too Little, Too Late?

Having ignored the inflation threat for far too long, many central banks, including the Bank of England, are now seemingly prepared to do whatever it takes to stop today’s high inflation from becoming entrenched. That includes gradually raising interest rates from their historic lows and beginning the process of reversing quantitative easing (QE) – something they should have done a long, long time ago.

Even the perpetually dovish European Central Bank (ECB) says it will begin raising rates once it winds down its purchases of government bonds, which it confirmed should happen at some point in the third quarter. As The Telegraph’s Ambrose Evans Pritchard notes tartly, “it is absurd that the eurozone still has rates of minus 0.5pc and is still doing QE at a time when inflation is 7.6pc in Germany, 9.8pc in Spain, and 11.8pc in Holland. But such is the absurd situation that the eurozone has got itself into under the structure of monetary union. The system may require negative rates in perpetuity.”

The Federal Reserve, like the BoE, has already begun cutting rates and expects to continue doing so at each of its remaining six meetings this year. If, like the last one, all of those moves are quarter-point hikes, the rate could reach a range of 1.75% to 2% by the end of 2022, the highest since 2019.

That is unlikely to be enough to bring inflation under control, for two main reasons:

1) The central banks can’t tighten hard enough without causing a big market sell off.

Since the GFC of 2008 central banks, through their asset purchasing programs and low, zero or interest rate policies, have been the driving force behind one of the biggest financial market bubbles of all time. But they have painted themselves into a corner. If they begin withdrawing monetary stimulus, there is likely to be a sharp sell-off of stocks, real estate and many other financial assets, in particular high-risk assets such as junk bonds. This is exactly what happened the last time the Fed tried to increase rates above 2%, in 2018: there was a sharp market sell-off, prompting the Fed to quickly reverse policy.

The irony is that for the Fed to have any chance of containing inflation, it would need to hike interest rates much more sharply than that. Analysts at Deutsche Bank have even called for a 5-6% Fed funds rate, which would almost certainly trigger a huge sell off across most markets, which could in turn spark another financial crisis. This leaves the Fed and most other central banks with little choice but to raise rates just enough to show they are doing something but not enough to have any meaningful impact on inflation. The upshot, according to US hedge fund manager Ray Dalio, is that the Fed is likely to be in a “very difficult place a year from now as inflation is still high and starts to pinch on both markets and the economy.”

2) Many of the forces driving inflation are far beyond the control of central banks anyway.

Those forced include Russia’s invasion of Ukraine, one of the world’s biggest cereal growers, and the US and EU’s ratcheting sanctions on Russia, one of the world’s most important commodity producers. This has unleashed all manner of mayhem across the global supply chains of a whole gamut of essential commodities including oil, gas, cereals, fertilizers and aluminium, as we warned would happen in our last newsletter. Food shortages are also becoming a very real danger.

The lockdowns in China risk further exacerbating the supply chain crisis, particularly for finished consumer goods, which is likely to fuel rising prices while also exerting a contractionary effect on a global economy that was already slowing down anyway.

Raising rates will almost certainly exacerbate this trend, squeezing yet more life out of the economy by making it even harder for heavily indebted businesses, home owners and consumers to service their debts. At the same time, it will probably do precious little to tame inflation (for the reasons just outlined). Central banks in emerging economies such as Brazil and Mexico have already repeatedly hiked rates over the past year yet inflation has continued to rise, reaching levels not seen in decades. At the same time, both economies have stagnated over the past four quarters.

In more advanced economies such as the UK, it appears to be just a matter of time before stagflation returns. Inflation is already setting new decade highs on a monthly basis. If recent business surveys such as the Germany-based Sentix economic indicator are a good indication, the other half of the equation – economic stagnation or recession – is on its way and is likely to hit European shores first. The question is: how long will it stay?