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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