------------------------------------------------------------------------
The Risk Is Inflation, Not Stagflation
Richard Berner (in Chatham)
‘Stagflation’ fears — concern that the future will entail high and rising inflation, low productivity gains and low earnings growth — are haunting investors again. Small wonder, because there appear to be some similarities with the stagflationary 1970s: US productivity growth slowed in the second quarter to 2.2% from a year ago and appears likely to slow further along with the economy. The supply shock from Hurricane Katrina spiked energy prices and, together with the dislocations from the storm, likely will slow near-term economic growth. Indeed, Katrina’s shock caps off a four-year tripling in energy quotes — which in the 1970s laid the groundwork for the stagflationary mix. And the likely fiscal stimulus designed to cushion Katrina’s blow seems simply to add to the kind of guns-and-butter fiscal policy that was a key ingredient for the poor economic performance of the 1970s.
By my reckoning, this is the fourth stagflation scare in the history of this 46-month-old expansion, and I’ll confess that on occasion my own worries have risen slightly (see for example, “The Curse of Arthur Burns,” and “Stagflation Ahead?” Global Economic Forum, October 22, 2004 and March 3, 2003, respectively). Nonetheless, as then, I’m increasingly convinced today that rising inflation and strong growth will go hand in hand. As I see it, dwindling slack in both labor and product markets together with a still-accommodative monetary policy will promote a gradual, cyclical rise in inflation following the recent lull.
But the tepid growth part of the stagflation call seems far less likely: Productivity growth is merely undershooting a healthy 21/2% trend, in my view, a trend that is double the one of the late 1970s and that can accommodate steady 31/2% real growth. Pent-up demand for capital spending and hiring is still unsatisfied, in my view. In addition, declining energy quotes and prospective fiscal thrust likely will more than offset Katrina’s hit to growth by next year. Nevertheless, the pace of economic activity seems unlikely to move far above trend on a sustained basis. Most important in this regard, Fed officials today are unlikely to make the mistakes of the 1960s and 1970s — mistakes that allowed inflation expectations to rise steadily and change consumer and business behavior.
The inflation part of my call or that of the stagflation enthusiasts is far from given. After all, incoming inflation data have lately turned benign. “Core” inflation measured either by the Consumer Price Index (CPI) excluding food and energy or by the personal consumption price index (PCEPI) excluding those two categories has slipped by about 0.2 percentage points from its peak early this year after rising steadily since early 2004. Long-term inflation expectations have also declined slightly over the past few months. For example, 5-10 year median inflation expectations in the University of Michigan’s survey of consumers slipped to 2.8% in late August from 3% earlier this year. Gains in import prices for consumer and capital goods have also faded from early 2005 peaks. After rising sharply in 2004, nonfuel commodity and industrial materials prices flattened out this spring. And the price diffusion indexes in business surveys also declined, in some cases sharply, from their 2004 peaks.
As I see the fundamentals, however, the case for a rebound in inflation is compelling. Slack in both product and labor markets has dwindled, and in my view even moderate economic growth will promote further firming in both, lifting both pricing power and wage gains. The so-called “output gap” in the economy overall has shrunk by more than 200 bp in the past 21/2 years, and may well disappear by the end of 2006. Courtesy of corporate discipline in capital spending, overall capacity growth in industry has remained at a 1.3% pace over the past year, after declining in 2003 for the first time in the 57-year history of the data. Excluding high-tech and motor vehicles groupings, capacity has been static since 1999. Moderate gains (4.3% annualized) in industrial output have lifted operating rates 500-600 bp in the past two years, and the change as well as the level of capacity utilization have enabled companies to raise prices without losing market share.
Although wage gains have thus far been tame, barely keeping pace with inflation, labor markets are also firming. The unemployment rate is now below 5%, and pent-up demand for hiring is still healthy, so I think wages are poised to accelerate (see “Are Labor Markets Tight?” and “Compensation Poised to Accelerate; Will Wages Follow?” Global Economic Forum, July 22, 2005 and April 25, 2005, respectively). With productivity growth slowing, unit labor and other costs thus seem likely to accelerate and companies with more pricing power should be able to pass some of those costs through to customers. Indeed, that’s the message in our early-September canvass of business conditions. The pricing conditions index rose to 68%, 57% of respondents noted that prices charged have increased from a year ago, and fully 31% reported that prices charged increased by 3% or more, the highest level in the history of the question. What’s more, 36% of respondents noted that companies under their coverage were able to increase prices faster than unit costs (see “Business Conditions: Pre-Katrina Reversal,” Global Economic Forum, September 9, 2005).
I’m convinced that productivity growth will undershoot its trend as hiring catches up with the economy, but a 1970s-style productivity slump is unlikely (see “Critical Juncture for Macro Policies?” Global Economic Forum, February 7, 2005). In fact, it’s not yet clear by how much productivity growth has slowed, because two key measures have diverged over the past eighteen months. Nonfarm business output per hour decelerated to 2.2% while labor productivity in nonfinancial corporate business accelerated to 6.4% in the year ended n the second quarter. While I’m suspicious that the nonfinancial corporate GDP data dramatically overstate productivity growth, they throw cold water on the case for stagflation.
Moreover, if anything, there are now some upside risks to our just-updated prognosis for economic growth in 2006. A key reason: The $62.3 billion in spending authority that Congress approved last week to help fund assistance for evacuees, cleanup and rebuilding is already higher than what we assumed in that scenario. And it seems likely that both the Administration and Congress are, over the objections of a few voices of fiscal prudence, likely to step up spending even more. From mobile homes to house the newly homeless to efforts to rebuild and strengthen Gulf Coast infrastructure, not to mention the city of New Orleans, there is no shortage of projects demanding Federal funding over the next several months. The increment to fiscal stimulus could easily top $100 billion. That spur to growth makes the case for stagflation a lot less likely.
For their part, Fed officials don’t seem likely to let down their guard about inflation, as evidenced by the chorus of hawkish comments from three not-so-hawkish reserve bank presidents last week. San Francisco Fed President Yellen opined that "uncertainties on the upside [for inflation] have only gotten bigger since Hurricane Katrina slammed into the Gulf Coast." Chicago Fed President Moskow stated concern “about core inflation running at the upper end of the range that I feel is consistent with price stability." And Philadelphia Fed President Santomero said a "measured pace" of rate increases "will continue to be appropriate" to keep inflation in check.
Market participants seem increasingly concerned about inflation, but I don’t think inflation risks are all in the price. While 5-year TIPS spreads widened by 10 bp over the past week and have risen significantly from their lows over the past six weeks, TIPS still represent better value than nominals, in my view. Both fixed income and equity investors should prize companies with pricing power, much of which will go straight to the bottom line. Yet investors should also pay attention to the quality of earnings, because some will now be the product of higher inflation.
What are the risks to my call? Near term, I think growth risks are biased slightly to the downside, and upcoming economic indicators may look fairly ugly for a month or so. Indeed, still-higher energy quotes and any consequent pullback by consumers are still clear risks. But there is also a real chance that recovery could come much sooner than expected, and that policymakers might have to scramble to catch up. |
