You remember the 1970s: We survived Watergate, wore bellbottoms, and danced to disco -- or maybe you watched your parents as they did. You may also remember gasoline lines following the 1973 oil embargo and skyrocketing energy prices. In the 1970s, we suffered two massive energy shocks, and the sustained jump in energy quotes seemed to usher in an era of “stagflation” -- a period of high and rising inflation, low productivity gains, and low earnings growth. By the end of that decade, the trend in inflation rose from 3% to 8%, trend productivity tumbled from over 2% to below 1%, and trend earnings at nonfinancial corporations excluding petroleum had tumbled from high single digits to zero. Does the combination of today’s post-bubble headwinds and a severe energy shock threaten a return to anything like that sorry economic environment? I strongly doubt it, but energy prices will have to fall substantially and growth will have to improve to erase the feeling that the growth/inflation mix will be unpleasant.
Post-bubble headwinds are still at work restraining the US economy; even absent the energy shock, first-half growth likely would manage only a tepid 2% annual rate. What I call restrictive financial conditions are key retarding factors, in my view. Primarily, that means sinking stock prices, but lingering credit restraint and the lagged effects of a strong dollar are also still hampering capital spending and US exports. In addition, while I believe that some pent-up demand is building for high-tech capital goods, that’s hardly universal. Demand for transportation and industrial equipment has stagnated, hinting at the potential for pent-up demand, but struggling airlines and manufacturers with still-slow earnings growth aren’t in a hurry to step up spending again. And of course, war-related uncertainty is contributing to business and consumer hesitation. With the US economy the only engine of global growth, and the US engine sputtering, vulnerability to shocks is high.
I don’t want to minimize the potential significance of the current energy shock; on the contrary, it has already raised the odds of renewed recession to one in four (see “How Much Do Shocks Matter?” Global Economic Forum, February 28, 2003). Moreover, the jury is still out on how long today’s energy shock will last, or for that matter, how big it will be, given the uncertainties surrounding war in Iraq and its possible aftermath. But so far, it is smaller and likely will be shorter in duration than those of the 1970s. Crude quotes more than tripled in 1973-74, and overall retail energy quotes rose by 60% over three years. The 1979 shock was even bigger at the retail level, with energy quotes rising a whopping 95% over three years. That was then. Today it is difficult to imagine that prices would rise so far for so long, and if we are right that energy prices will peak for two months at a crude equivalent of $40/bbl., we estimate that today’s energy/confidence shock will trim first-half growth by three-quarters of a point at an annual rate.
A curious paradox is nonetheless unfolding. Unlike in the 1970s, deflation is a bigger risk than stagflation, or than higher inflation, at least for now. In the 1970s, the rise in energy prices hit when lax monetary policy nurtured inflationary psychology and capacity use was high. Industrial operating rates in 1978 exceeded 85% -- nearly 10 points higher than they are today. In contrast, I believe that energy shocks today tax growth more than they boost inflation. The potential for higher energy prices to filter through to costs -- and thus to “core” inflation and inflation expectations -- is one set of forces. But more powerful and working in the opposite direction, an extended period of sluggish global growth, ample capacity, and relatively restrictive policies abroad all argue for lower, not higher global inflation.
Yet at the same time, three factors are beginning to incubate a rebirth of pricing power. First, “capital exit,” or the process of cutting back on capacity growth and ultimately shrinking capacity itself is well under way. Second, the Federal Reserve’s commitment to fight deflation, evident in speeches and testimony from Chairman Greenspan, Governor Bernanke, and others sends market participants an important message: We’ll do whatever it takes. The concomitant decline in the dollar against most currencies is a manifestation of that policy stance, one that is helping to boost corporate profits. Finally, stronger growth ultimately will lift inflation expectations and firm pricing for Corporate America (see “The Rebirth of Pricing Power,” Global Economic Forum, December 22, 2002). And that last part is critical: Without stronger growth, the nascent upswing in pricing power likely will perish stillborn.
Are any stagflation fears creeping into the price of any financial assets? Fixed income markets seem to be discounting a worsening growth/inflation outlook. For example, the TIPS spread -- the spread between yields on conventional Treasury notes and those on Treasury Inflation Protected Securities, and which often proxies for inflation expectations -- has widened by 55 bp to 175 bp since crude prices began to surge. What’s unusual in this episode is the way this spread widening has occurred. In the past, these spreads have widened when the bond market has sold off and nominal yields have risen. This time, spreads have widened as TIPS yields have declined by more than those on conventional Treasuries. The sharp decline in real yields as represented by those on TIPS -- now at 1.71% for 10-year issues -- and widening spreads seem to hint at a whiff of stagflation.
My colleague Bernd Wuebben has noted that TIPS yields are highly correlated with energy price swings, which also seems to imply that price action in TIPS reflects stagflation fears (see “TIPS on Fire,” February 25, 2003). If that correlation persists, sizable declines in energy prices might trigger higher TIPS yields and TIPS underperformance (see “Could TIPS Underperform Treasuries?” February 28, 2003). Investors should interpret swings in TIPS spreads with care, however: Wider TIPS spreads could reflect stagflation fears, but Bernd cautions that there is no guarantee that this energy price-TIPS relationship will hold up. Time will tell, but my guess is that higher energy prices will widen such spreads even further, while lower energy prices would narrow them. In other words, even though stagflation is unlikely today, market participants may not want to take the chance that it won’t make a comeback.
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