Stagflation creeping in: BMO’s Cooper

Interest rates are not in the double digits they were 30 years ago, but increased concern among central banks that inflation is on the rise during a period of relatively slow growth has led BMO Capital Market’s chief economist, Sherry Cooper to conclude stagflation is on the way.

In her latest review on the economy, entitled The New Stagflation, Cooper says the world’s major central banks seem to be focused on inflation-fighting — the latest example being last week’s rate decision by the Bank of Canada not to cut its trend-setting bank rate.

The reluctance of central banks to ease rates comes in the face of a general slowdown in economic growth, prompting Cooper to predict the rest of 2008 may well be a period of stagflation, especially in the United States.

“For now, central banks are preoccupied with the potential for upside pressures on inflation. While none doubt that the surge in oil and food prices dampens demand and discretionary spending and reduces corporate profitability for most companies, inflation is apparently seen as a bigger potential problem than recession,” she writes. “Financial instability and the credit crunch have, for now, descended in importance. A moderate version of stagflation may well be the outlook for the rest of 2008.”

Cooper places the blame for inflation fears squarely on the shoulders of rising commodity prices — energy prices in particular.

“Consumers, already weakened by massive wealth destruction in housing and financial stocks along with a slowing job market, are further squeezed by rising fuel prices. The current drain on consumer income from rising gasoline prices is greater than it was during most of the worst energy-price run-ups of the past,” she says. “Spending on fuel as a share of wage income has shot above 6%. That exceeds the percentage seen during the 1974-75 and 1990-91 oil-price shocks and approaches the 7% to 8% seen during the 1979-81 price surge. Comparing the rise in fuel spending to U.S. consumer income growth, which has been especially weak in recent years, the current shock is far worse than any of the three prior ones.”

While energy prices are exacting a real toll on businesses and consumers alike, economists and analysts face a conundrum: soaring energy costs do not play a role in core inflation, upon which central banks base their decisions. Reported core inflation rates appear rather tame, but the complete set of Consumer Price Index (CPI) data includes food and energy prices, painting a very different picture.

“Core inflation, or inflation without food and energy, grew at 2.3% [in the U.S.],” notes John Mauldin, a recognized financial expert, and editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. “Inflation without food costs was an even 4% and without energy was 2.7%. Clearly energy was the leading contributor to inflation in the past year.”

In his latest newsletter, Mauldin says the recent trend in rising inflation is even more worrying because if you look at just the last three months of data and compute an annualized rate of inflation, overall inflation has risen to 4.9% and energy inflation is running at 28%.

“Meanwhile, core inflation during that period dropped to 1.8%. Food (over 14%) and energy (over 9%) combined make up roughly 24% of the CPI, yet were responsible for over 60% of the recent three-month trend in inflation,” he writes. “What would it take to drop headline inflation back to under 2%? Well, one way would be for food and energy prices to fall.”

Mauldin thinks oil prices have reached their “tipping point,” but he warns food prices could continue to swell.

“As [BMO’s] Donald Coxe has noted, North America has had an 18-year run of remarkably good weather in our growing season,” he says. “You have to go back 800 years to get a string of years that were that good. Yet today food reserves of all types are at decades-long lows. There is very little room for any type of problem.”

One painful solution for central banks would be to increase interest rates. Mauldin estimates a 2% rate increase would be necessary to stem the tide of rising food and energy prices. In his opinion the consequences would be too severe for the slumping U.S. economy.

Mauldin says low rates have allowed lenders in the battered financial services sector to maintain a positive yield curve on borrowing and deposits. Using a chart, he outlines that a 2% rate increase would invert the yield curve.

“If you raise rates by 2%, you would more than likely invert the yield curve, making it that much more difficult for financial services companies to be able to recover. Given that they are already in trouble, and therefore less able to lend to businesses and consumers, do you really want to make things worse?” he says. “Another inverted yield curve would do serious damage to an industry already reeling. We are going to see more write-offs from banks. This chart will get uglier, but it will collapse without a positively sloped yield curve.”

The stagflation thesis has its detractors. TD Bank Financial Group’s chief economist Don Drummond says that current inflation fears are overstated. Drummond doesn’t see low growth and inflation co-existing. He believes one will eventually drag the other down.

“I think inflation fears have been overblown lately. I’m towards the pessimistic end on growth for the United States and Canada. If you look at our economic forecast relative to the average, for most out there we do think it will be well into 2009 before we get a meaningful recovery in Canada and the United States. That will cap inflationary pressures,” he says. “We see in the U.S. case, core inflation staying just a little bit above 2%. In Canada’s case it’s somewhere around the 2% mark, which of course is the Bank of Canada’s actual target.”

Drummond believes if energy prices don’t drop, they will at least flatten — further allowing sagging growth to offset inflationary pressures.

“As oil prices increase, it feeds into the headline inflation and certainly the actual measure will be high for quite some time. We don’t think that there is a great risk of that filtering through to unacceptable levels,” he says. “We are somewhat lower on the oil price expectations. We don’t see it going up further on the sustained basis and of course that will flatten out some of the recent pressure as well.”

A greater sense of the effect food and energy prices are having in Canada will be available on Thursday, when Statistics Canada releases its Consumer Price Index data.

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(06/16/08)

Mark Noble