Global Stagflation Ahead?

Global Stagflation Ahead? The Interplay Of Aggregate Demand And Aggregate Supply Shocks

By Nouriel Roubini | Jun 10, 2008

The recent rapid rise in commodity prices— oil, energy, metals and agricultural commodities— is leading to the concern that the ensuing rise in global inflation may be associated with a slowdown of global economic growth if not an outright global recession; i.e. there are rising worries about stagflation, a deadly combination of rising inflation and economic recession.

Indeed, not only inflation is rising in many advanced economies and emerging market economies but there are signs of a likely economic contraction in many advanced economies (the US, UK, Spain, Ireland, Italy, Portugal, Japan). In emerging market economies the rise in inflation has been associated so far with rapid economic growth and economic overheating; but there are worries that the economic contraction in the US and other advanced economies may lead to a growth recoupling— rather than decoupling— in emerging markets at the time when rising inflation is forcing monetary authorities to tighten monetary and credit policies to control rising inflation; so "stagflation lite", i.e. rising inflation cum sharply slowing growth may soon become a problem also for emerging market economies. So should we worry about stagflation or "stagflation lite"?

Let us analyze this issue in more detail...

A true stagflationary shock requires a negative supply-side shock that increases prices/inflation while reducing output/growth. Instead, positive aggregate demand shocks— like an overheating in emerging markets following a growth in aggregate spending— would be associated with rising inflation and rising growth. It can be observed that truly stagflationary shocks— that led to a global recession— occurred three times in the last 35 years: in 1973-75 when oil prices spike following the Yom Kippur War between Israel and several Arab states and the ensuing oil embargo imposed by some Middle East producers of oil; in 1979-80 following the Iranian Revolution that led to an even larger increase in real oil prices; in 1990-91 following the Iraqi invasion of Kuwait that also led to a sharp— if temporary— increase in oil prices.

And even the 2001 recession— that was mostly triggered by the bust of the tech bubble of the 1990s— was also accompanied by a doubling of oil prices following the beginning of the second Palestinian intifada against Israel. So, in [all] these cases— especially in the 1970s episodes— a geopolitical negative shock to the supply of oil triggered a stagflationary outcome. Of course the two major stagflationary shocks in the 1970s were exacerbated by the monetary policy response that tried— for a while— to prevent the reduction in equilibrium growth rates and rise in the natural rate of unemployment that such a persistent negative supply shock entailed; thus, the unhinging of inflation expectations— and eventual need to reverse monetary policy to fight inflation— exacerbated the stagflationary outcome for the global economy.

Today, such a true stagflationary shock may be the result of a— now more likely— Israeli attack against Iran’s nuclear facilities. This geopolitical risk has increased in likelihood in the last few weeks following the growing Israeli alarm about the nuclear ambitions of Iran, Iran’s reluctance to freeze its uranium enrichment program, Iran’s president growing bellicose statement about wiping out Israel from the face or the earth, and the alleged leanings of the current U.S. administration to tacitly support an Israeli strike against Iran before the US elections.

Certainly such an Israeli attack against Iran would trigger a sharp increase in oil prices— well above $200 a barrel— that would be caused by many factors: an increase in the fear premium; the risk that Iran would reply by unleashing its allies in Iraq, Lebanon (Hezbollah) and Gaza (Hamas) provoking a broader regional war; the risk of an attempted Iranian blockage of the Straits of Hormuz; and the possibility that Iran would use the economic war weapon— a sharp reduction in the production and export of oil— to spike the price of oil.

And the consequences of such a stagflationary spike in oil prices would be a major global recession such as those provoked by the geopolitical stagflationary shocks in 1973, 1979 and 1990. And indeed the recent week’s rise in oil prices is due— in part— to the increase in this fear premium as noise about an Israeli strike against Iran some time this year has increased. But short of this stagflationary shock triggered by a geopolitical conflict could we observe a stagflationary outcome in the global economy?

In the 2004-2006 period global growth was robust while inflation was low. This ideal situation can be interpreted as the outcome of a positive global supply shock— the increase in productivity and productive capacity of China, India and emerging markets— that allowed global growth to increase while prices of goods and services remained low or falling because of the rise of Chindia, of the BRICs and more broadly of more productive emerging market economies.

This positive supply side shock was followed— starting in 2006 but more strongly in 2007— by a positive global demand shock: the fast growth of demand in Chindia and other emerging market economies started to put pressure on the demand and prices of a variety of commodities and lead to a rise in inflationary pressures. Thus, strong global growth in 2007 was associated with the beginning of a rise in global inflation, a phenomenon that with some caveats— the sharp slowdown in growth in the US and some advanced economies— continued in 2008.

The above analyses thus suggest that— barring a true supply side stagflationary shock such as a war with Iran— a true stagflationary outcome (rising inflation and recession) is unlikely in the global economy. The recent rise in oil, energy and other commodity prices is— in spite of the deepening US recession— the result of a variety of factors, rather than a mere negative supply side shock. First, high growth in demand for oil and other commodities among fast growing and urbanizing emerging market economies at the time when the supply of new oil is constrained the political instability— and ensuing lack of enough investment in new oil exploration— of a number of unstable petro-states (Nigeria, Venezuela, Iran, Iraq and, possibly, Russia) while the supply of other commodities is constrained in the short run by productive capacity and need for longer term investments.

Second, the weakening US dollar that pushes the dollar price of oil higher as the purchasing power of oil exporter over non-dollar regions is reduced. Third, the discovery of commodities as a new asset class by many investors (hedge funds, pension funds, sovereign wealth funds) leading to both short run speculative and long run investment demand for commodities. Fourth, the diversion of land towards bio-fuels production; this is a phenomenon that has reduced the land available to produce agricultural commodities [[and, paradoxically, increased consumption of petrofuels and petrochemicals: normxxx]]. Fifth, very easy monetary policy by the US forcing easy monetary policy in countries that formally peg to the US dollar (as in the Gulf) or that heavily manage their exchange rates to maintain 'undervalued' currencies [to maximize] export led growth (China and other informal members of what is referred to as the Bretton Woods 2 "dollar zone") leading to a new asset bubble in commodities and overheating of their economies. Most of these factors are akin to global aggregate demand shocks— rather than supply shocks— that should lead to growth overheating and a rise in global inflation.

The last factor— the exchange rate policies of many emerging market economies— is particularly important. In most of these economies large current account surpluses and/or rising terms of trade imply that the equilibrium real exchange rate (the relative price of foreign to domestic goods) has appreciated; thus over time the actual real exchange rate needs to converge— via a real appreciation— towards the stronger equilibrium one. If this adjustment of the real exchange rate is prevented or delayed by not allowing the nominal exchange rate to appreciate the only other way in which the real appreciation can occur is through an increase in domestic inflation.

Indeed, policies of forex intervention that tried to prevent the nominal appreciation have led to a massive increase in foreign exchange reserves whose effect on base money has been only partially sterilized; thus the ensuing low policy rates and increases in monetary base growth and of credit growth have eventually led to both asset inflation (real estate bubbles and equity bubbles) and, more recently, to goods inflation as the recent rise in inflation in most emerging market economies shows. Thus, the most important way to control inflation— while regaining monetary and credit policy autonomy that requires higher policy rates to control inflation— is to allow currencies in these economies to appreciate significantly rather that prevent such appreciation. Indeed— as Triffin’s Inconsistent Trinity principle suggests[-1-]— under conditions of large capital mobility maintenance of fixed exchange rates— or heavily managed exchange rates— is incompatible with achieving monetary policy and credit policy autonomy.

At the end of the day the fundamental instability of Bretton Woods 2 has to do with the tensions that Triffin’s and Mundell’s “Inconsistent Trinity” entail: in an world where capital mobility is increasing and attempts to have capital controls are widely failing (even in China) as such controls are very leaky, emerging market economies have to choose between maintaining fixed exchange rates and losing all monetary and credit policy independence or giving up fixed exchange rates and achieving monetary independence. In the medium run, the rational choice for large economies such as the BRICs— Brazil, Russia, India, China— is to have monetary independence as such independence is essential to fine tune their large and complex open economies. Also, such economies are large enough that they can grow a vast domestic market for their output: they are large enough that reliance on net exports— rather than consumption and investment for domestic markets— as the main source of growth is not necessary. But regaining monetary autonomy implies phasing out fixed exchange rates. Among the BRICs, Brazil, India and Russia are already well ahead— if not yet fully— going in that direction of exchange rate flexibility. China is not there yet but it may soon abandon fixed exchange rates given the rising costs of BW2[-2-].

Unfortunately this need for currency appreciation and monetary tightening in overheated emerging market economies is occurring at a time when the effects of the housing bust, the credit crunch and high oil prices in a number of advanced economies (US, parts of Europe and in Japan that depends heavily on US growth) is leading to a sharp economic slowdown in these advanced economies— and outright recession in some of them— that, in due time, will slow down growth in emerging market economies as economic recoupling will emerge. Thus, rising inflation and slowing growth in many advanced and emerging economies is becoming a nightmare for their central banks that should be tightening monetary policy to fight inflation and ease monetary policy to reduce the downside risks to growth.

If the nature of the shock hitting the advanced economies is now a negative aggregate demand shock— a fall in demand driven by the bust of housing and the ensuing credit crunch— inflationary forces should— over time— diminish as there will be, especially in economies entering a recession, three forces that will tend to reduce inflation: a slack of aggregate demand relative to aggregate supply reducing the pricing power of firms (and indeed we are already seeing deflation in the US in home prices, auto prices and consumer durables); a slack in labor markets where a rising unemployment rate will lead to a reduction in wage pressures and labor costs; and eventually a fall in commodity prices from their recent peaks if a severe US contraction leads to a global economic slowdown and lower demand for commodities; indeed a fall in global commodities demand— given short run inelastic supply of commodities— would lead to a relatively sharp— about 20% plus— fall in commodity prices.

So in the last decade we got a full circle of first positive and now negative aggregate supply and aggregate demand shocks in the global economy: following a benign period of a positive global supply shock— the rise of Chindia and emerging markets that increased growth and lowered inflation— we saw a global demand shock that led to global overheating (especially in emerging markets) and a rise in inflationary pressures; next, there are now worries about both a stagflationary negative supply shock— if a war with Iran does occur— and a deflationary aggregate demand shock as housing bubbles going bust and the ensuing liquidity and credit crunch limit aggregate demand in many economies.

Thus, deflationary pressure in some economies that are contracting could occur in parallel to inflationary pressures in economies that— so far— are still growing fast. Certainly the year ahead will be a much more difficult one for the global economy and central bankers as a combination of rising inflationary risks and downside risks to growth is emerging in complex and different ways for different economies.

The Fed is now signaling its concerns about rising inflation and inflation expectations— especially with a weakening US dollar— but it is still recognizing that there are significant downside risks to growth. Thus, in spite of the new hawkish rhetoric the Fed will stay on hold— and may even ease further— if the US [slowdown] turns out to be severe and prolonged rather than short and shallow. The ECB is even more hawkish given its mandate giving priority to price stability; but its aim to tighten monetary policy to stem inflationary pressures will be challenged by the rapid growth slowdown of Europe where high oil prices, a credit and liquidity crunch, a strong euro, anemic real wage growth, a weakening of the U.S. and the lack of policy rate easing are taking a toll on growth even in Germany while a number of other European and Eurozone economies are headed towards a hard landing (Spain, Ireland, Italy, Portugal and the UK).

For U.S., Europe and Japan a rise in oil and commodity prices is "stagflationary" even if it is driven in part by strong demand in emerging market economies. So while rising inflation caused by the commodity shock may require tighter monetary policy, the weakening in demand caused by a different combination of housing busts, credit crunches and other factors weakening growth (such as strong currencies in Europe and Japan) is leading to a rapid slowdown and outright contraction in some economies. Whether monetary policies will be tightened or kept on hold will depend on how much the [perceived] downside risks to growth become larger than upside risks to inflation.

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The Complacency That The Worst Was Behind Us In Financial Markets Is Rapidly Fading Away

By Nouriel Roubini | Jun 3, 2008

The complacency that took hold of financial markets (equity and partly credit)— after the bailout of the Bear Stearns’ creditor and the extension of the lender of last resort support of the Fed to systemically important broker dealers (those that are primary dealers)— is rapidly fading away as financial markets and financial institutions are again under severe stress.

Let Us Detail How

Independent analysts of the banking system and of other financial intermediaries have clearly pointed out that the massive writedowns and losses of financial institutions will continue as the credit losses spread from subprime to near prime and prime mortgages; to commercial real estate loans that had similarly poor underwriting standards; to unsecured consumer credit (credit cards under stress given the balance sheets of households, auto loans that are in big trouble with auto sales plunging, student loans whose market is now frozen); to leveraged loans and bridge loans that financed reckless LBOs that should have never happened in the first place; to muni bonds now that distressed municipalities— see Vallejo in California as the canary in the mine— will experience an onslaught of muni bonds defaults; to monoline insurers battered by a double whammy of muni bonds under stress on top of the trouble of toxic MBS and CDO that were wrapped into monoline guarantees; to industrial and commercial loans as many debt burdened firms are in trouble; to corporate bonds as hundreds of billions of dollars of junk bonds were issued in the last four years by heavily indebted and poorly performing corporations; to the CDS market where $62 TRillion of nominal protections— that was sold by a small group of broker dealers, hedge funds and monoline insurers— is sitting on top of an outstanding stock of only $6 TRillion of corporate bonds; with the ensuing risk that the losses among the sellers of protection will lead to some of them going belly up and thus show to the buyers of protection that there was [and is] no hedge as counterparty risk rears its ugly head.

These delinquencies, defaults and bankruptcies have only started to rise outside subprime mortgages but they are now mounting in a tsunami of rising losses as the subprime disaster was only the tip of an iceberg of a credit bubble that run amok across the economy and across many and different credit markets. No wonder that now heads just started to roll at the top of Wachovia and WaMu; that Lehman— even with the protection of the Fed liquidity blanket— is in trouble again; that Countrywide is on the verge of bankruptcy once BofA pulls out of a loser acquisition of the biggest and most insolvent mortgage lender; that the troubles among mortgage lenders are now spreading to the UK where the housing bubble was as big— if not bigger— than in the US; that S&P has finally downgraded major financial institutions; and now that more financial trouble lurks ahead for major US banks and smaller US banks (small banks that will go into bankruptcy by the hundreds as the housing recession deepens, home prices collapse and the economic recession deepens and persist longer than expected by the market consensus).

So after a brief period of complacency— if not delusional optimism that the worst was behind us— a painful reality check is setting in. Fed Funds easing and new liquidity facilities (TAF, TSLF, PDCF, Swap lines) of the Fed cannot resolve insolvency and credit problems that go well beyond illiquidity. A contracting economy, falling employment for months now, the worst US housing recession since the Great Depression, collapsing home values, millions of households underwater with an incentive to walk away from their home, a shopped out and saving-less and debt burdened US consumer buffeted by falling home prices, falling HEW, falling stock prices, rising debt servicing ratios, oil at $130 a barrel and gasoline at $4 a gallon, collapsing consumer confidence and falling employment are all taking the toll on the economy, on financial markets, on banks, on the shadow financial system and on money markets and credit markets. We were in the eye of the storm rather than past the storm; and the recent events and developments suggest that the worst is yet ahead of us, for the economy, for equity markets, for credit markets and for money markets.

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Normxxx    
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