June 16, 2008
The Bottom Line: The New Stagflation

Dr. Sherry Cooper
Executive Vice-President
Global Economic Strategist, BMO Financial Group
Chief Economist, BMO Capital Markets & BMO Nesbitt Burns

In a surprise move, the Bank of Canada refrained from trimming overnight interest rates on June 10th despite the negative posting for Q1 GDP and the threat of a global slowdown. At the last policy decision on April 22nd, the Bank had said "some further monetary stimulus will likely be required to achieve the inflation target over the medium term”. The Bank now joins the Fed and the ECB in a shift to mounting inflation concern that seems to portend a growing probability of rate hikes down the road. Just how far down the road, of course, depends on the future path of inflation, growth and financial market distress. While the financial crisis appears to have ebbed, recent worries regarding Lehman Brothers, UBS and others have taken U.S. financial stocks to new lows, and triggered renewed growth concerns.

Chairman Bernanke and a number of Fed officials have been making hawkish statements regarding the need for inflation vigilance and a stronger dollar. The Fed will not raise rates simply to strengthen the currency. They never have and never will take responsibility for currency market intervention or manipulation, and even the U.S. Treasury, whose job is to determine dollar policy, sees no imminent need to interfere in currency markets, although Treasury Secretary Paulson wouldn’t rule it out. While a weak U.S. dollar has increased import prices, it has also made American products more competitive abroad and at home. The dollar's weakness is a key reason why the U.S. economy has continued to expand—albeit slowly—over the past six months.

Were it not for the sharp rise in commodity prices, particularly energy, the U.S. trade deficit would have fallen significantly. American households and businesses are conserving energy now that prices have increased sharply, but not enough to reduce the net import of energy in current-dollar terms. Consumers, already weakened by massive wealth destruction in housing and financial stocks along with a slowing job market, are further squeezed by rising fuel prices. The current drain on consumer income from rising gasoline prices is greater than it was during most of the worst energy-price run-ups of the past. Spending on fuel as a share of wage income has shot above 6%. That exceeds the percentage seen during the 1974-75 and 1990-91 oil-price shocks and approaches the 7%-to-8% seen during the 1979-81 price surge. Comparing the rise in fuel spending to U.S. consumer income growth, which has been especially weak in recent years, the current shock is far worse than any of the three prior ones.

Consumer confidence in the U.S. is already very low, and while it has recently fallen in Canada, consumer sentiment here is far better for fundamental reasons. Living standards and real incomes are growing in Canada in direct contrast to the net decline in consumer purchasing power in the U.S. Housing markets here are still reasonably strong, but are gently slowing from the breakneck pace of recent years, especially in the commodity bull markets of Western Canada. Canadian household wealth is now a record 5.5 times disposable personal income, while U.S. household wealth has fallen sharply. U.S. homeowner equity has plunged and U.S. stocks have underperformed vis-à-vis Canadian stocks. Moreover, the relative weakness in the U.S. dollar has grounded many Americans from foreign travel or expensive import purchases, unlike Canadians who are travelling with a strong loonie.

Not surprisingly, American voters want change. President Bush’s approval rating continues to fall and has recently hit a new low. With the Presidential campaign in full throttle, Americans are reminded that one of the promised outcomes of the war in Iraq was to lower oil prices, which were at $30 a barrel when the war began. Each bit of incoming bad news on the economic front is highlighted and enlarged by the 24/7 media, contributing to the malaise and concern about the economic and financial outlook.

On the positive side, however, at least gasoline is available. The oil crises of the 1970s and early 1980s reflected actual shortages and line-ups at the pumps that gobbled many hours of what could have been productive time. As well, consumers and businesses are far more fuel-efficient today than they were during the oil shock of the mid-1970s, requiring half as much energy to produce a unit of economic output. Also, interest rates are far lower than they were back then, helping reduce the burden of home ownership and other borrowing. But there is no doubt that Americans are tightening their belts, even at the higher end of the income scale. And, industrial and emerging economies are feeling the pinch of higher oil prices and reduced U.S. demand for their products.

Newly released data from the International Energy Agency (IEA) suggest that global oil demand growth is slowing in response to high prices. For example, Americans drove 11 billion fewer miles in March versus the same month a year ago—the sharpest monthly drop since the government began collecting such data in 1942 and the first contraction in that month since the 1979 Iranian revolution. That was well before gasoline hit $4 a gallon, so further cuts in demand are likely.

China, the second largest consumer of oil after the U.S., is expected to boost oil demand this year. But as oil price subsidies are cut in parts of Asia, demand growth is slowing.

The International Air Transport Association, which represents 230 airlines globally, says premium travel for business and first-class services suffered its biggest drop in five years in March and that economy travel growth slowed to less than 1% at the end of the first quarter. Consumers throughout the industrial world have cut back on personal driving and more are using public transportation. Sales of light trucks and SUVs are plunging and the auto industry is rapidly stepping up development of smaller, more energy-efficient cars, while shutting down production of gas guzzlers. Businesses in general are cutting work days and travel, and are opting for teleconferencing and other means to replace face-to-face communication over multiple locations.

But don't expect significant relief on the price side. Inadequate oil supply seems to have more than offset the deflationary impact of slackening demand. Rising development costs, a lack of investment spending, and equipment bottlenecks are hampering oil production projects. Non-OPEC supply this year is now expected to grow by just 500,000 barrels a day—half the level expected many months ago. Even OPEC leaders, such as Saudi Arabia, are experiencing delays in bringing new fields into service, and President Bush, on a recent trip, left Saudi Arabia with little to show for his efforts to encourage production.

In its recent report, the IEA said OPEC is pumping at near capacity; spare production capacity has dipped to below 2 million barrels a day, an historically low level after years of underinvestment. While Saudi Arabian supply is important to the U.S., oil imports from Canada are even larger, providing Canada with enormous bargaining power in any future NAFTA negotiations if the Democrats win the Congress and White House. Presidential candidate Obama now says that he is a free-trader at heart.

Oil price pressures are filtering through other sectors of the economy, most notably chemicals, plastics and all modes of transportation. Farmers are punished by the high cost of energy, fertilizer and other commodity inputs as food prices have also risen sharply. While some prices, such as wheat and rice, have fallen recently, flooding in the U.S. Midwest and drought in Australia could retrace those declines and more as this growing season unfolds.

As corn and sugar are increasingly allocated for biofuels, global food prices have risen sharply. The quantity of arable land is in limited supply, much of which has been diverted to corn, pushing the price of other grains and crops skyward. Food riots have been seen in more than 30 countries and even in the Western world, food price increases are markedly reducing restaurants visits and other discretionary spending.
While the Fed seems relatively sanguine about the possibility of a 1970s-type wage-price spiral as labour markets are weakening, Bernanke is concerned about a potential rise in inflation expectations. Overnight interest rates in the U.S. and Canada may be low now, but Chairman Bernanke seems to be suggesting that the current 2% target Fed funds rate might be hiked before year-end barring renewed economic weakness. Yield curves have already steepened sharply as two-year yields have surged in both Canada and the U.S. reflecting the rising prospects of inflation-induced rate hikes. Longer-term bond yields are increasing as well.

At least in Canada, labour markets remain reasonably strong and real income growth is rising far faster than real product growth. The surge in the U.S. jobless rate in May from 5% to 5.5% is troubling even though some special factors may have been at play. When measured on an equivalent basis, the Canadian jobless rate is below the unemployment rate in the U.S. for the first time since 1982. U.S. employers shed 49,000 jobs last month—a fifth-straight monthly decline, while net jobs in Canada continued to grow.

Global policymakers are increasingly focussed on inflation. The Bank of Canada, in response to the incoming data, has "judged” that inflation risks are now to the high side, even though the economy has "moved into excess supply, which is expected to increase this year.” They continue to believe, however, that growth will pick up later this year and accelerate in 2009.

The Fed as well is heartened by the considerable resilience of consumers over the past five years. The U.S. government's $168 billion economic-stimulus program, largely built around tax-rebate cheques, is lessening some of the impact of the current price shocks. But gasoline prices have increased more than $1 a gallon since the economic-stimulus plan cleared Congress in February, which will mitigate the rebate boost.

The Bottom Line: For now, central banks are preoccupied with the potential for upside pressures on inflation. While none doubt that the surge in oil and food prices dampens demand and discretionary spending and reduces corporate profitability for most companies, inflation is apparently seen as a bigger potential problem than recession. Financial instability and the credit crunch have, for now, descended in importance. A moderate version of stagflation may well be the outlook for the rest of 2008.

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