Could stagflation be staging a comeback? The spectre of the 1970s is haunting the stock market as the latest round of rising prices proves stickier than most policy makers expected.
In Canada, the pace of inflation has exceeded the top end of the bank’s target range for five consecutive months. In August, the consumer price index (CPI) accelerated at a 4.1-per-cent annual rate, the highest level since 2003.
In the United States, the Federal Reserve’s preferred gauge of pricing pressures has been running at more than double the 1.8-per-cent pace the Fed forecasted at the start of the year. During August, inflation in personal consumption expenditures (PCE) ripped ahead at a 4.3-per-cent annual clip.
Until recently, central bankers were quick to reassure the public that this inflationary swell was just a transitory phase as economies recovered from pandemic lockdowns. But even diehard members of Team Transitory are now beginning to acknowledge that price pressures won’t vanish any time soon. At a panel discussion this week, Fed chair Jerome Powell said he expects supply chain bottlenecks and other issues to continue into next year, “holding up inflation longer than we had thought.”
Stock markets are not okay with that. They have struggled in recent weeks. In Toronto, the S&P/TSX composite index lost 0.5 per cent over the third quarter, while the benchmark S&P 500 index in the United States eked out a microscopic 0.2-per-cent gain over the same period and the tech-heavy Nasdaq index lost 0.4 per cent.
More weakness could lie ahead. If inflation persists, bond buyers will probably demand added compensation for the risk that rising inflation will gut their returns. Bond yields and interest rates will rise.
If yields rise high enough, investors could desert risky stocks for bonds. That would pose a challenge for today’s lofty share prices, especially if higher interest rates also drag on the economy, leading to a stagflationary blend of higher inflation and lower growth.
To be sure, today’s inflationary bumps are still sub-5-per-cent molehills compared with the double-digit mountains of the 1970s. But there are reasons for concern.
Over the past two months, yields on benchmark 10-year government bonds in the U.S. and Canada have jumped from below 1.2 per cent to around 1.5 per cent – a big and unsettling move by the staid standards of the government bond market. Much of the rise has taken place over the past week and a half.
The Federal Reserve meeting on Sept. 21 and 22 provided a key impetus. The U.S. central bank signalled at the end of the meeting that it would soon begin tapering its massive bond-buying program, a tool it has used with great gusto during the pandemic to help keep interest rates low.
Any slowdown in the Fed’s bond-buying spree increases the chance of interest rates rising over the next few months. (If everything else stays the same, less Fed buying means lower bond prices, and lower bond prices imply higher yields.) This is exactly what one would expect in a recovering economy. The question, though, is how large the rate increases will be.
Half of Fed policy makers expect the key Fed funds rate to remain stuck near zero next year. The rest see no more than one or two rate hikes in the cards for 2022. The median expectation is for the Fed funds rate to move up modestly, from around 0.1 per cent now to around 0.3 per cent next year.
What to make of this forecast? Optimists can view it as reassuring evidence that the global economy is slowly but surely returning to normal.
Pessimists, though, will see plenty of reasons for worry. According to the Fed brain trust, inflation will fade to around 2.2 per cent in 2022. What if policy makers are underestimating the persistence of inflation? What if they are also underestimating the size of the rate increases that will be required to tame inflation? If so, the Fed could be creating the conditions for stock market mayhem.
“The more rate volatility increases, the greater the risk of yields suddenly ‘gapping’ upwards given that we are starting with a combination of very low yields and extremely one-sided market positioning,” Mohamed El-Erian, an economist and president of Queens’ College, Cambridge, wrote in a Financial Times essay this week.
“The greater the gapping, the bigger the risk to market functioning and financial stability, and the higher risk of stagflation – the combination of rising inflation and low economic growth.”
The key is what happens to inflation. Skeptics of current policy – call them inflationistas – tend to focus on three main arguments:
- Inflationistas argue that governments have pumped so much stimulus into their economies over the past year that demand is overwhelming supply in sectors that can’t quickly boost output. See soaring home prices and spiralling oil prices for examples of this dynamic at work.
- They also worry that rising home and oil prices are combining with supply-chain disruptions to shatter people’s belief that inflation is under control. If so, and inflationary expectations rise as a result, workers could start pressing for bigger wage increases while companies push for larger prices increases. Result: Higher inflation.
- In the eyes of inflationistas, central banks seem to have gone soft on inflation. After being pilloried for their role in boosting inequality in the wake of the financial crisis, many policy makers – notably those at the U.S. Fed – say they will now raise rates only when there is evidence of broad, inclusive growth that benefits all sectors of society.
“The Fed has created the conceptual possibility that it could accept inflation running in the 2.5 per cent to even 3 per cent range for five years,” Joel Naroff of Naroff Economics LLC said in a note Friday. “I continue to believe that trend inflation will be closer to 2.5 per cent than 2 per cent when things ultimately settle down,” he added.
Team Transitory isn’t much impressed by such concerns. Stimulus measures are fading and supply-chain kinks will work themselves out over the next year or so, they say. As for central bankers, both the Fed’s Mr. Powell and Tiff Macklem, the Bank of Canada Governor, have emphasized their commitment to stable and low inflation over the long haul.
The strongest single argument of the transitory camp is that the 2020s are not the 1970s. Back then, wage-price spirals drove inflation higher. Strong unions demanded wage increases. Powerful manufacturers rammed through compensating price increases.
These days, neither side wields the same muscle. Union clout has faded. Few companies possess true pricing power. If most tried to goose prices, global competitors would swoop in and undercut them.
For investors, the raging debate over inflation illustrates an important point: We still don’t have a clear understanding of what drives prices persistently higher. In the 1950s, U.S. inflation spiked as unemployment tumbled during the Korean War but price pressures quickly subsided without any drastic Fed tightening. In the 1970s, very similar conditions – low unemployment, the Vietnam war – preceded years of stagflation and massive Fed tightening.
The one thing that seems most certain in the current environment is that the long and largely uninterrupted rise of the stock market since the pandemic lows of last year is looking increasingly at risk. Stagflation or not, investors would do well to adjust their expectations.
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