Morgan Stanley has a good piece today which predicts the US may be in for stagflation, similar to the 1970s. This means we can get used to
low GDP growth and
high inflation, in essence the worst of both worlds. The main reason, according to Morgan Stanley for the
stagflation scenario is
Fed policy, which actively encourages
inflation. Furthermore, the
Fed will be purposely slow to tighten monetary policy.
From Morgan Stanley:
How close are we to a
1970s scenario? There are similarities as well as differences.
Similarities
• An international monetary system with ‘peripheral' economies importing
the Fed's monetary policy stance through a currency peg or quasi-peg (see "
QE20", The Global Monetary Analyst, October 13, 2010). It is, of course, no coincidence that the current monetary arrangement has been dubbed ‘Bretton Woods 2'.
• A glut of
dollars due to superexpansionary
Fed policy:
China, Germany and others have made little effort to hide their discomfort over
QE2, and the dollar fell substantially in foreign exchange markets before a renewed flare-up of the euro area sovereign crisis allowed it to recover somewhat.
• A two-track global
economy: Similar to the early
1970s, the rest of the global economy is doing just fine - indeed many of the EM economies of the ‘Bretton Woods 2' periphery are, if anything, in danger of overheating. Note that by 2012, EM will make up 51% of the
global economy under our coverage (measured in PPP weights) and the G10 the remaining 49%. And we know from recent experience that red-hot EM
economies have a voracious appetite for commodities - for example, 33% of the increase in global
oil consumption between 2003 and 2006 came from
China.
• Structural change which lowers the
economy's speed limit: The crisis has likely destroyed potential output and reduced the potential
growth rate over the medium term as consumers deleverage and many economies retool from shrinking sectors such as construction towards expanding sectors such as manufacturing. Thus, again, central banks may be overestimating the amount of spare capacity in the
economy.
Differences
• Structure of the
oil market: Unlike in the early 1970s when the
price of oil was fixed,
oil quotes now adjust instantaneously to changes in the
economic outlook. Indeed, since
Fed Chairman Bernanke hinted at
QE2 in August, inflation expectations have risen and
oil has rallied. (Incidentally, that is as it should be: like stocks,
oil is a real asset which should provide inflation protection in the long run.)
• The
US economy is weak and
unemployment is high: Yet US data have been improving before the
Fed bought even a single
QE2 dollar's worth of securities. Just as importantly, what matters for inflationary pressure is not the absolute level of the
unemployment rate but the distance from the speed limit (the level of
unemployment consistent with
stable inflation). As mentioned above, it is very likely that, in the post-crisis world, this speed limit is substantially lower (the
unemployment rate consistent with stable
inflation substantially higher):
inflationary pressure could therefore emerge at
higher unemployment rates than before the crisis.
• The structure of the economy: no wage indexation: There is no question that widespread wage indexation contributed to the persistence of
high inflation in the 1970s. However, the lack of wage indexation nowadays does not mean that
inflation cannot rise in the first place. Besides, wage indexation was put in place in response to
high inflation. That is, just because there is no wage indexation now does not mean that higher
inflation in the future would not result in the indexing of wages.
All of this does not, of course, make
inflation or stagflation a foregone conclusion.
Yet in a global economic environment with the following factors, we think that in the medium term the risks are skewed towards an overheating of the global economy (especially in EM), elevated commodity quotes and ultimately higher inflation:
• The
Fed will want to err on the side of caution with respect to draining excess reserves (a premature tightening of reserve requirements may have led to a recession in 1937 as banks responded by slashing lending in order to restore their desired level of excess reserves - see "Reversing Excessive Excess Reserves", The Global Monetary Analyst, October 28, 2009);
• The
Fed will want to err on the side of caution with respect to normalising policy rates (Japan's premature exit from ZIRP (zero interest rate policy) in 2000 will likely serve as a deterrent) - this will likely keep real interest rates low;
• It is difficult to estimate the
economy's speed limit (indeed, easy to overestimate the degree of slack in the economy);
• More generally, risk-averse global
central banks prefer the threat of
inflation to the one of deflation (see "Better the Devil You Know", The Global Monetary Analyst, August 18, 2010); and
• Public and private debt levels are very high, creating incentives to generate or acquiesce to
inflation (see "Debtflation Temptation", The Global Monetary Analyst, March 31, 2010).
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