Stagflation occurs when economic growth fails to offset rising inflation, meaning real growth (which is what catches the headlines) is negative, but the prices of goods and services rise. Many economists have fretted that an unintended consequence of giving away free money, via quantitative easing (QE) and ultra low interest rates, is that prices ultimately rise but nothing extra is produced. Of course, the potential for that to happen may have been exacerbated by massive government spending and disruption to global JIT (just-in-time) manufacturing processes.
Still, one would have thought our leading central bankers would have been aware of the potential for stagflation under such circumstances. They may have tightened policy and rolled back the great QE experiment to help prevent the imbalances that rising prices can cause.
There are signs that stagflation is happening right now across the globe. For example, energy prices are spiking and this can push up the cost of many goods and services without anything actually being produced.
Much has already been written about this energy crisis in Europe, but there are other equally dangerous developments that hint at stagflation. In Germany, levels of factory production have collapsed, led by a shortage of automotive computer chips. Indeed, the latest data show car production 26% below last year’s levels. Meanwhile, not surprisingly, prices for second-hand cars have rocketed. The much-quoted Manheim Survey highlighted a 5.3% price rise in September alone. No production and rising secondary prices: classic stagflation.
This is not just happening in Europe. The latest US jobs data look very poor. Only 194,000 jobs were created compared with a consensus forecast of 500,000. But worse still, the unemployment rate dropped to 4.8% from 5.2% and that’s before the implementation of the huge US stimulus packages. People left the workforce in droves, while those in work did longer hours for an extra 4.6% of pay.
This is a horrible dataset for risk assets, especially if it’s repeated in coming months: labour force shrinkage, rising earnings and more hours worked points to an economy constrained domestically as well as by global supply chain factors. It’s another classic sign of stagflation.
Raising interest rates a year ago might have curbed consumer borrowing for second-hand cars in the US – the price of which is up 25% since 2020. It may also have reduced the massive wealth effect, possibly temporarily, experienced by many in the US – stock market bubbles, Bitcoin surges and housing booms – and helped maintain the labour force at a healthier level for future growth. Many of these people might return to the jobs market when inflation eats into their stock market and windfall gains of course. But part of the central bank’s role has traditionally been to smooth these periods, whereas recent policy seems to have been to exaggerate the wealth cycle, potentially leading to major corrections further down the line.
There are big implications here. Will central banks reign in bond-buying programs to counter inflation? Will that roil the equity market? If central banks do nothing and inflation surges, damaging consumption and corporate margins, will equities be roiled even more? We can already see the warning signs of stagflation and, even if it proves transitory, it can have damaging effects in the short term. The extent to which it becomes embedded and the degree to which central banks react could be crucial for investment returns over the next year.