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STAGFLATION is defined as a period when a nation is experiencing an unprecedented and uncontrollable spike in inflation rate at a time when economic growth is slowing down or stagnating. In the past, this slow growth is also accompanied by rising unemployment as a slowing economy makes it difficult for jobs to be created and for the workforce to be employed.
Central banks globally recognise that fighting stagflation is never going to be easy. Typically, stagflation itself is due to three main factors – a loose monetary policy; the government’s pump-priming efforts via increased government spending to generate economic growth; and of course, supply shocks, which lead to higher raw material prices, which in turn, results in higher inflation. Sounds familiar?
The story in the 1970s
History explains that the stagflation of the 1970s was a result of a few events coming together as the United States President then, Richard Nixon, halted wages and prices for 90 days, imposed a 10% tariff on imports, and the famous move of detaching the US dollar from the gold standard.
While the objective was to tackle the runaway inflation in the US, to provide better jobs, and to safeguard the dollar, the combined actions had a significant impact on the Federal Reserve’s (Fed) monetary policy. While it raised rates to fight inflation early on, the Fed had no choice but to cut rates after the US went into a recession.
The US experience shows that stagflation is harmful to the economy as it sends wrong signals to investors, resulting in many making wrong decisions, especially when asset prices are rising.
In a period of a sustained high inflation rate, central banks will have no choice but to raise rates. Once this is done, it affects investments decisions as rising rates will cause benchmark yields to rise significantly, resulting in losses for bond investors while markets too will correct due to higher interest rates.
High interest rates will dampen businesses too as higher borrowing cost leads to lower private investments, while consumers will fend-off spending on big-ticket items.
Inflation running wild globally
From Washington to Auckland inflation is on the path of sustain increases caused by two main factors. First is the unprecedented money supply that was created globally by major central banks that appears to be coming to a stop while the uneven post-pandemic global recovery over the past three to six months shows that supply disruption is the greatest threat to rising prices.
Commodity prices, as measured by the Bloomberg Commodity Index, is on a tear, as it is close to 40% firmer over the past year. This has caused most economies, except for Japan and to a certain extent China, to experience inflation prints well above target rates and with that pressure for central banks to react.
For the Fed, what appeared to be transitory earlier now looks to be sustained and hence the Fed too will have to react, sooner or later, to this pressure. To recap, the headline and core inflation print for October 2021, which came in at 6.2% and 4.6% respectively, were the highest in three decades.
While the Fed has now laid out its plan to reduce its bond purchase programme starting with US$15bil (RM62bil) this month, it is in no hurry to raise rates anytime soon as it awaits the labour market to show a stronger recovery. Although the core Personal Consumption Expenditure (PCE) reading is above target, which will compel the Fed to naturally react, the relatively soft labour market is causing the Fed not to pull the trigger on rates and declare a liftoff just yet. Will the Fed be proven right or wrong?
According to Bloomberg Economics’ nowcast, “across the US, Europe, and Asia, the nowcasts are flagging a slowdown in the recovery, with activity still some way short of the pre-pandemic trend.
More troubling, in many major economies, inflation looks set to stay stubbornly above central banks targets.”
The slowing global economy going into the final quarter of 2021 and next year is a consequence of the near “V” shape recovery that we witnessed in the first half of this year, which inevitably will normalise.
This is not unexpected as the economy makes adjustments from the big bounce experienced in the preceding quarters, which has resulted in a high base for most economies.
Will we see stagflation?
Two of the three conditions that define stagflation is likely to occur and hence we may be lucky in avoiding stagflation as unemployment at this stage is not an issue for most economies.
In fact, to the contrary, certain economies are experiencing tough labour market conditions as displaced workers, due to the pandemic, are not returning to full-time employment, but instead have emerged as a new gig economy workforce, with the preferred choice of working on their own and freelancing.
However, although unemployment is not a concern for most central banks, for now, the recipe that has brought us to where we are today has all the classic ingredients for stagflation to take place.
All eyes are now on how central bankers globally will maneuver rate hikes going into 2022 and beyond to tackle sustained high inflation rates.In the recent Federal Open Market Committee (FOMC) meeting, the Fed chair, while clearing the path for its widely expected tapering move starting this month and up to mid-2022, did not refer as to the timing of a rate hike but warned that should the situation warrant a response, the Fed will not hesitate to raise rates.
For now, half of FOMC members see a rate lift-off in 2022 while the market is forecasting two rate hikes next year.
However, with the runaway inflation print in October, the market has brought forward the rate lift-off to June 2022, with the second rate move in November 2022.
The Fed is not expected to stand pat and raise the benchmark rate by another 25bps as early as February 2023, making it up to three rate hikes over a period of nine months between June 2022 and February 2023.
The risk of a policy misstep is rising
No central bank in the world wants to be ahead or behind the curve when it comes to rate hike decisions. While decisions to raise rates are undoubtedly data-driven, especially on core PCE, unemployment, and economic growth, there is always a chance that central banks may end up being behind the curve when it comes to rate hikes, especially one that is too little too late.
As it is, the US 10-year breakeven inflation is stubbornly high at 2.70% while the five-year breakeven inflation reading is even more telling, rising to a fresh record high of 3.08% on Wednesday as seen in the chart on the breakeven inflation rate.
As it is, the long end of the US treasury curve has already inverted with the 20-year US Treasury last seen at 1.96% against the long bond yield of 1.92%. With persistent inflationary threat, slowing economic growth, stagflation fears are here to stay and this may dampen the Fed’s dot plot going into next year, especially when the market is pricing a very different scenario.
Be prepared for volatile markets in 2022
Other than economic growth data points, the key element for markets is the expected rise in global interest rates. As it is, certain central banks have already made the move for lift-off from the ultra-low rate environment and more are expected to do so in 2022.
As the market is up against a smaller liquidity injection due to the Fed’s tapering move, and potential rate hikes, it will be a challenging year for equity and fixed income markets as investors will be up against a rising interest rates environment.
The tide is turning and investors may be in for a wild ride, especially if the flight to safety takes precedence over bubble-like asset prices we see today across most asset classes.
Pankaj C Kumar is a long-time investment analyst. The views expressed here are his own.