By Mike Lenhoff 20/04/2007 00:00
Stagflation, that uneasy combination of high inflation and slow growth, is not back as we knew it, neither in substance nor even in degree.

Yes, inflation remains stubbornly above central bank targets, as in the UK, or near the upper boundaries of price stability, as in the eurozone, or above comfort zones, as in the US, but this is not because economic activity is weak or sluggish. On the contrary, it’s because growth remains surprisingly resilient, even in the US. It’s also because of the unexpected strength of commodity markets - oil in particular.

In the US, economic growth is slowing and so is productivity growth. Partly as a result of the latter, unit labour cost growth is rising, as the chart shows (dotted line). Not only is unit labour cost growth a key influence on core inflation but it also determines what happens to profit margins. As the chart also shows, profit margins are being squeezed (solid line).

The attempt by companies to reclaim or maintain growth in profit margins will put upward pressure on inflation. If pricing power is re-appearing after a long period of absence, this may be because inflation expectations are on the rise - although the Fed tells us that these are well anchored - or, more to the point, because demand is strong enough to support it.

Granted there is weakness in the US housing market but more jobs than expected are being created and the growth of consumer spending remains surprisingly buoyant and unaffected by the weakness in the housing market and the state of the sub-prime mortgage market.

The Fed is not alone in fretting about pricing power. So is the Governor of the Bank of England. Indeed, so is the ECB.

In fact, all things considered, the expansion in the global economy is proving to be surprisingly robust all round. Credit market spreads on higher yielding debt are still historically narrow suggesting there is confidence in the outlook for global growth (see Tight Credit Spreads - Smart Money or an Accident waiting to Happen? 11 April 2007). It’s ‘boomsville’ and that may be why inflation is proving to be stubbornly resistant to the tightening efforts of the central banks.

Stagflation’s not back. It’s the cycle that’s back!Moreover, the cycle is maturing and what makes it somewhat different today is that the developing economies are big time players. Not only are they major producers of commodities, they are among the major consumers of commodities.

Stagflation was born out of the 1960s. Much of that decade, as the chart below shows, was a golden age of growth for the major economies. By the latter half of it, there was little, if any, slack in labour markets and wages and prices had begun to spiral. While that sowed the seeds of the stagflation of the 1970s, various other factors were implicated including an explosive rise in commodity prices in the early 70s, the first oil tremors of 1973/4 and accommodating monetary policies.

In October 1979 the new Chairman of the Federal Reserve changed the course of history. Under the stewardship of Paul Volcker, the Fed shifted from targeting the Federal funds rate to targeting bank reserves (specifically nonborrowed reserves) as a basis for controlling the money supply.

Interest rates shot rapidly upwards and remained excessively volatile. The Fed altered policy again after the back-to-back recessions of the early 80s. That recessionary phase brought stagflation to an end and paved the way for an era of disinflation.

The features that characterized the stagflation of the 1970s, like rising rates of unemployment and high double digit inflation and interest rates - real rates were negative - are not present today. But like the late 1960s, the slack in labour markets has diminished or is diminishing, as reflected in low and/or falling rates of unemployment in the major economies.

Also, as the chart below shows, the sharp rise in commodity prices in recent years is reminiscent of those earlier times that preceded the stagflation of the 1970s. Much has been learned about the conduct of monetary policy since then. This time round, the central banks have no intention of being accommodating.

But will they need to raise rates by much? Only if the global economy is heating up. While emerging Asia, notably China, may be heating up, that does not apply to the major economies. So, although the cycle is maturing, we still reckon that interest rates in the major economies will not rise a whole lot further.

In the US we’re talking about the Fed maintaining the Funds rate at 5.25 percent. If the growth of employment falters, say because of poor growth in profitability and investment, the Fed will cut, but probably not before. In the UK and the eurozone, we see policy rates at 5.75 percent and 4 percent max respectively. In Japan, the BoJ is not likely to raise rates again before the trend of inflation picks up and that’s not likely for some months.

Is this bad news for bonds and equities? Bond markets might provide a slightly better buying opportunity but not a vastly better one. As for equity markets, we can only repeat what we have said before: if earnings hold up, which they should against the backdrop described, the equity markets will not come to much harm. Higher interest rates will subject them to more volatility, but volatility cuts both ways. It means equity markets can go up as well as down.

* The information contained in this report has been taken from public sources and is believed to be reliable and accurate, but without further investigation cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Securities Ltd. No Director, representative or employee of Brewin Dolphin Securities Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in or options on the securities mentioned herein or may buy, sell or offer to make a purchases or sale of such securities from time to time. In addition we reserve the right to act as a principal or as agent with regard to the sale or purchase of any security mentioned in this document. Prices, values or income may fall against the investor’s interests. You should therefore be aware that you may get less back than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio, you should seek the advice of a qualified investment adviser.