Stagflation - Upside Inflation and Downside Growth

 

The timeframe for stagflation has never been well-defined, nor is the definition of stagflation well understood. It is more complex than being a shortfall in growth from long-term trend with inflation. It is also more than a productivity shortage.

Yet, as a google trend search topic it is currently quite popular. Most economists would suggest that it is a long-term structural issue that can last a decade; however, our only strong stagflation experience in the US was in the 1970's. Some would point to macro events in the 1940's and 1950's, but the growth and inflation numbers were not near the levels of the 1970's.

We can have short-term stagflation when there is strong inflation upside but strong downside growth risks. There can easily be divergence between growth and inflation. There is no reason that high growth and inflation always have to be positively correlated. 

Of course, there can be supply shocks that contribute to slower growth, but a supply shock is not the same as a general increase in prices. Currently, the global economy is facing two supply shocks, energy and trade congestion. In that sense, we are facing growth constraints and higher prices.  

The US economy is facing a supply shock through trade bottlenecks while demand is still high from loose fiscal and monetary policy; two key conditions for stagflation. It may not be a long-term situation, but it is real and can create policy and investor confusion. It is not clear policy-makers have tools for solving the supply shocks, It is not clear whether investor should react to the immediate dislocation or focus on longer-term expectations. 

The value of history for economics from Charles Kindleberger

“Economics needs history more than history needs economics.” - from Charles Kindleberger’s great work, Manias, Panics, and Crashes

This quote from Charles Kindleberger is one of the more insightful recent comments on economics I have seen. I was rereading Manias, Panics, and Crashes and this line jumped off the page. History is important. It provides context.

Economists generally have a high opinion of their science versus the other social sciences and the liberal arts. It would like to consider itself in the same league as physics. It is not. Economics need historical clarity because it generally cannot run experiments. 

I would say that the best investment analysts are students of history. To understand today needs a deep sense of where we have been and the path to any current situation. Central bankers are slaves to past monetary crises. Consumers are constrained by their past fears. Businesses fight the last strategic battle and usually don't see the threats of the future. Forward expectations are tempered and biased by the past. Yet, a poor understanding of the past leads to the wrong conclusions.

Economics always need to ground theory, tests, and narrative to the time, place, and structures of the past. History looks to make sense of a wide set of events and tries to find commonality and causality. Lessons from the past are wrongly learned through the misinterpretation of history.

New Zealand central bank raises rates 25 bps - A start, but not a constraint on speculation

The New Zealand Reserve bank raised rates 25 bps to a new level of 50 bps this week, the first increase in seven years, yet this action will not change the NZ inflationary picture. Real rates are still just inside negative 3 percent because current inflation is above 3 percent and still rising. Speculation will continue when real rates are so negative.

The move by central banks to normalization has begun around the globe with a push raise nominal rates and limit the real rate extremes. However, given the high inflation in many countries like New Zealand, there is no real change in the monetary liquidity situation. There are no binding constraints on money, so housing bubbles will continue. 

Inflation dispersion and skew creates inflation uncertainty that cannot be controlled by Fed

Supply shocks. Demand shocks. Logistics shocks. Pandemic shocks. The big recovery and reflation. You can pick one or several reasons the dispersion of prices in the inflation indices have exploded. Of course, for the mean inflation to be higher, dispersion has to be skewed to the upside. Big changes for small components in the price basket create noise and inflation volatility. It also means that high inflation could just be the skewed adjustments of prices within the selected basket of goods. As the businesses and consumers get their production and buying decisions right, inflation will recede. 

Transitory inflation could be another way of saying that as skewed dispersion closes, inflation will move back to some central tendency slightly above the 2% target. This wishful thinking is less likely if we are living in a logistical congestion nightmare. 

In this product congestion world, the Fed is helpless at controlling current inflation. Of course, this does not let the Fed off the hook as a cause of the problem. The Fed could use its power to slow demand in order to allow supply and logistics to normalize. Given this choice is not at all preferred, the other alternative is just saying the problem will fix itself and hope it goes away. This seems to be the current approach. Given time, logistical issues will be solved, and inflation will normalize.