Rising prices, fragile economy resurrects stagflation as market threat

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Could a stagflation comeback be staged? The ghost of the 1970s haunts the stock market as the latest round of rising prices proves to be more sticky than most policymakers expected.

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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) rose at an annualized rate of 4.1 percent, the highest level since 2003.

In the United States, the Federal Reserve’s preferred gauge of pricing pressures is running at more than double the 1.8-percent pace forecast by the Fed at the start of the year. During August, inflation in personal consumption expenditure (PCE) further accelerated at an annual clip of 4.3 per cent.

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Until recently, central bankers were quick to reassure the public that this inflationary growth was just a fleeting phase as economies recovered from pandemic lockdowns. But even staunch members of Team Transitory are now beginning to believe that the price pressure won’t end anytime soon. In a panel discussion this week, Fed Chairman Jerome Powell said he expects supply chain bottlenecks and other issues to continue into the next year, “keeping inflation going longer than we thought.”

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Inflationary recession? recession? Bond market messages stun investors

The stock markets are not okay with this. He has struggled in recent weeks. In Toronto, the S&P/TSX Composite index lost 0.5 percent in the third quarter, while the benchmark S&P 500 index in the United States gained a subtle 0.2-percentage over the same period and the tech-heavy Nasdaq index lost. 0.4 percent.

Further weakness may come. If inflation persists, bond buyers will probably seek additional compensation for the risk that rising inflation will affect their returns. Bond yields and interest rates will rise.

If the yield rises sufficiently, investors may abandon riskier stocks for bonds. This would present a challenge to today’s high stock prices, especially if higher interest rates also drag on the economy, leading to a stagnant mix of high inflation and low growth.

To be sure, today’s inflationary odds are still sub-5-percent molehills compared to 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 US and Canada have risen from below 1.2 per cent to nearly 1.5 per cent — a big and troubling move by the stagnant standards of the government bond market. Most of the increase has happened in the last one and a half weeks.

The Federal Reserve meeting on September 21 and 22 provided a significant impetus. The US central bank indicated at the end of the meeting that it would soon begin to ease its massive bond-buying program, a tool it has used with great enthusiasm during the pandemic to help keep interest rates low. done for.

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Any slowdown in the Fed’s bond-buying spree raises the chances of a hike in interest rates over the next few months. (If everything else remains the same, less Fed buying means lower bond prices, and lower bond prices means higher yields.) That’s exactly what would be expected in a recovering economy. The question, however, is how big will the rates be.

Half of Fed policymakers expect the key fed funds rate to remain near zero next year. The rest don’t see more than one or two rate hikes in the cards for 2022. The average expectation is for a modest increase in the fed funds rate, from about 0.1 percent now to about 0.3 percent next year.

What to do with this forecast? Optimists can see this as reassuring proof that the global economy is slowly but surely returning to normal.

However, pessimists will see many reasons for concern. According to the Fed Brain Trust, inflation will drop to around 2.2 percent in 2022. What if policymakers are underestimating the persistence of inflation? What if they are also underestimating the size of the rate hike needed to beat inflation? If so, the Fed could cause a stock market catastrophe.

Mohamed El-Arian, a Queens-based economist and president, “the more rate volatility increases, the greater the risk of a sudden upward move in yields, as we begin with a combination of very low yields and extremely one-sided market conditions.” are doing.” ‘ College, Cambridge wrote this week in an essay for the Financial Times.

“The greater the gap, the greater the risk to market functioning and financial stability, and the higher the risk of stagnation – the combination of rising inflation and low economic growth.”

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The main thing is what happens to inflation. Skeptics of current policy – ​​calling them inflationists – focus on three main arguments:

  • Inflationists argue that governments have given so much stimulus to their economies over the past year that demand outweighs supply in sectors that cannot increase production quickly. See rising house prices and rising oil prices for examples of this dynamic at work.
  • He also worries that rising households and oil prices are coupled with supply-chain disruptions, eroding people’s confidence that inflation is under control. If so, and inflation expectations rise as a result, workers may begin to push for larger wage increases, while companies push for larger price hikes. The result: high inflation.
  • In the eyes of inflation experts, central banks seem to be softening on inflation. After being bullied for their role in widening inequality in the wake of the financial crisis, many policy makers – in particular the US Fed – say they will now raise rates only if there is evidence of broad, inclusive growth that will benefit all sectors of society. benefits to. .

“The Fed has created the ideological possibility that it could accept ongoing inflation in the 2.5 percent to 3 percent range for five years,” Joel Naroff of Naroff Economics LLC said in a note Friday. “I believe that when things finally settle down, the trend inflation will be closer to 2.5 percent, compared to 2 percent,” he said.

Team Transitory is not much affected by such concerns. They say that stimulus measures are fading away and the supply-chain glitches will go away on their own in the next year or so. As for central bankers, both the Fed’s Mr. Powell and the Bank of Canada’s governor, Tiff McCalem, have emphasized their commitment to stable and low inflation over the long term.

The strongest single argument of the temporary camp is that 2020 is not 1970. At the time, wage-price spirals further exacerbated inflation. Strong unions demanded wage hike. Powerful manufacturers offset the price hike.

These days, neither side has the same amount of muscle. The dominance of the union is over. Few companies have true pricing power. If most tried to drive down prices, global competitors would swoon and undercut them.

For investors, the raging debate over inflation reflects an important point: We still don’t have a clear understanding of what drives a steady rise in prices. In the 1950s, US inflation increased as unemployment declined during the Korean War, but price pressures quickly subsided without any drastic Fed tightening. In…

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