Stagflation concerns overblown

SERIOUS MONEY:FEARS THAT 1970s-style stagflation - a sustained period of stagnant growth and high inflation - have become front-page news and the growing debate has recently featured in the Financial Times, New York Timesand the Wall Street Journal.

The issue has gathered pace of late as monthly US consumer price data continue to disappoint, recording three consecutive months of annualised gains in excess of 4 per cent.

Concerns have been compounded by higher oil prices, which again breached $100 a barrel in recent sessions, the seemingly relentless upward momentum in agricultural commodity prices and the decline in the dollar to record lows against the euro.

The Federal Reserve has lowered growth expectations for 2007 sharply in its latest economic forecasts, while inflation estimates have been raised above the board's comfort zone.

Not surprisingly, the Cleveland Fed's liquidity-adjusted approximation of inflation expectations for the next 10 years, imputed from inflation-protected securities, have soared by roughly 90 basis points since last summer to more than 3 per cent.

But are suspicions that the United States' only peacetime era of significant inflation is set to repeat truly legitimate?

There is no doubt that the current investment climate bears certain similarities to the 1970s, including a bull market in oil, agricultural commodities and precious metals, alongside a bear market in equities and the dollar, not to mention a deeply unpopular war. However, that is where the similarities end.

The phrase stagflation was first coined by British parliamentarian Iain Macleod in 1965, but did not gain traction until the 1970s. It was a time when few western policymakers, apart from the Germans, had the stomach to "lean against the wind" as memories of the Great Depression were vivid.

But once the inflation genie was let out of its bottle, confidence in central banks' commitment to price stability and their ability to contain inflationary pressures plummeted.

Two extreme supply side-shocks - the Yom Kippur war of 1973 and the Iranian revolution in 1979 - compounded the misery through sharply higher oil prices.

The race to invest in "black gold" contributed to a productivity slowdown. The inevitable result was high inflation and sub-par growth.

But conventional wisdom that the two Opec crises were the source of high inflation is wholly untrue.

The seeds of stagflation were sown in the 1960s as Lyndon Johnson fought dual wars throughout his presidency - one in Vietnam and another on domestic poverty through his Great Society programme.

Lax monetary policy combined with strong unions set the stage for a dramatic wage-price spiral. Economic mismanagement also placed considerable downward pressure on the dollar and the fixed exchange rate regime that had persisted since the second World War - a system that broke in 1971 when Richard Nixon relinquished the greenback's link to the gold standard.

The resulting fall in the dollar caused the oil-producing countries to seek compensation through higher prices. Stagflation had arrived.

A repeat of the 1970s is unlikely. The worst credit crisis in modern history and the subsequent unavailability of funds is clearly deflationary and spells danger for the US's beleaguered consumers.

The ongoing housing meltdown does not bode well for households that carry a record amount of debt and other liabilities relative to the market value of their assets, and have relied heavily on asset-price gains in recent years to fund their irresponsible spending binge.

Indeed, the Federal Reserve notes that those households with a home equity line of credit allowed their savings rate to drop from almost 10 per cent in 1991 to minus 13 per cent in 2005 and, despite some improvement since then, the rate remains seven percentage points below zero.

Declining household wealth alongside a softer labour market and limited access to credit does not paint a pleasant picture, and a day of reckoning may be at hand.

The inability to secure financing at a reasonable price has implications for the corporate sector as well.

Although corporate America's balance sheet is in excellent shape, more than one-half of all corporate bond issuers are now rated as junk or below investment grade.

The surge in interest costs has already seen a number of leveraged loan issuers experience financial difficulty, and default rates are sure to move higher in the months ahead.

Investors need to be aware that inflation is a lagging indicator and is sure to trend lower as the full impact of the credit crunch is felt.

Stagflation concerns are overblown and further interest rate cuts are likely.

The declining cost of money, combined with lingering inflation concerns, means that the secular bull market in gold remains intact and an assault on $1,000 per troy ounce seems assured.

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