The spectre of stagflation

The spectre of stagflation
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First Published: Tue, Nov 06 2007. 12 09 AM IST
Updated: Tue, Nov 06 2007. 12 09 AM IST
This column has written more than once on the appeal of gold and on the return of inflation in a world that has been used to reflation by central banks in response to all troubles.
Last week was a defining moment. It reinforced these early indications that the problems are beginning to press against the limits of control and management.
Three countries in Asia and one in Eurasia reported inflation for October. All the countries reported higher inflation than expected. At 3%, South Korean inflation was the highest in two years. In Thailand, inflation rose to 2.5%. It was at its lowest in August at 1.1%. This was anticipated as the price of crude oil had dipped last summer. As the price of crude oil began to move higher this summer, eventually, the effect of comparing a rising price of oil to the falling price last summer would begin to show through. Inflation in Indonesia was barely higher than expected and about 10 basis points lower than September.
More importantly, China decided to raise the price of petrol, diesel and jet fuel by 10% with immediate effect. The Chinese President had only recently warned against any hasty price liberalization until inflation stabilized. But the rising price of crude oil had reduced refining margins for petroleum-refining companies. They had begun to balk at producing refined products without adequate compensation. That led to long lines of people waiting to buy petrol and diesel. The government had to act. It did, and after 17 months of no price change, raised fuel price. Clearly, the technocrats are more concerned about the costs of inaction while politicians are fearful of the uncertain consequences of acting. The parallel with India is remarkable. Inaction on fuel prices is adding to the fiscal deficit in the country and is not sending signals to the public on the changed demand-supply dynamic of this non-renewable source of energy. What this signals to investors is that their cup of love for “IC” among the Bric countries is already too full.
So far, the consensus has been that China would refrain from taking any decisive tightening measures until after the Olympics. That consensus still holds but some in that country are uncomfortable with rising imbalances. When that country decides to act against rampant speculation in asset prices, its consequences would be felt globally and more acutely in Asia, as China, with its ultra-low real rates, has been the global fountain of liquidity.
But a small piece of consolation for the rest of Asia is that a cooler Chinese economy would not be such big negative, for a red-hot economy was not such a big engine of growth for it. Research by the Federal Reserve Board published in September suggests that China was at best a conduit for more developed Asian countries and that countries in the region remained vulnerable to a slowdown in growth in industrialized countries. Obviously, among them, America is the key.
Recent economic data from the US have not given much room for concern. In fact, they had vindicated the mildly aggressive stance taken by the Federal Reserve on 31 October, after cutting the Federal funds rate to 4.5%. GDP growth in the third quarter was nearly 4% (annualized) and the labour market added 166,000 jobs in October. But look closely, GDP data showed that private demand grew by just 1.5% (annualized). Accumulated inventories—most of it in the auto sector and hence, involuntary—and government sector made sizeable contributions to growth. This was reinforced by the data on new orders released in the purchasing managers’ index for October. Net of inventories, new orders are declining. A comprehensive leading measure of national economic activity prepared by the Federal Reserve Bank of Chicago called the “Chicago Fed National Activity Index” shows the economy within striking distance of stalling in September and heading further in that direction.
Perhaps that explains why the bond market was unimpressed with the October employment data. Far from the bond yields rising on that news, they fell (prices rose) on that day. The euro reached new highs against the dollar and gold crossed $800 per ounce. Clearly, despite turbulence in financial markets, gold has held its own. In the bond market, while nominal bond prices rose, prices of inflation-indexed bonds rose even more. It means that the bond market’s expectation of future inflation in America went up. Action in the gold, bond and stock markets in recent weeks suggests that markets are beginning to take the risk of stagflation seriously. Besides precious metals, under-valued real estate (not that easy to find globally and, more so, in India) and food commodities, not too many assets would do well in times of stagflation.
Investors should take note.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at baretalk@livemint.com
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First Published: Tue, Nov 06 2007. 12 09 AM IST