We have long warned that stagflation, or economic contraction accompanied by
inflation, would become so evident that even the most optimistic observers
could not deny its virulence.
Last week, Warren Buffet was the latest to describe his encounter with the
beast. The world's most famous investor pronounced that the current economy is
in the middle stages of a stagflation episode. Although Mr Buffet is not
typically associated with either bullish or bearish sentiment, he asserted that
both the "stag" and "flation" aspects of the condition would intensify before
they relent. So, if we can all recognize the wolf at the door, can we agree on
the best course of action?
Unfortunately for policy makers, different weaponry is called for to
vanquish the two heads of the stagflation dragon. Recession can be held at bay
by lowering interest rates, while inflation is usually tamed by raising
interest rates. Given the impossibility of pursuing both courses of action
simultaneously, priorities come into play. Historically, inflation has been
considered the greater long term economic menace and has therefore been dealt
with first.
This was the plan of attack successfully mapped out by President Reagan and US
Federal Reserve chairman Paul Volcker in the 1980s. With the president's
political backing, Volcker was able to kill stagflation with a short but heavy
dose of double-digit interest rates. With the stable currency and low inflation
that resulted, the stage was then set for a sustained and robust economic
expansion.
Present Fed chairman Ben Bernanke has recognized the stagflation threat for
some time, but rather than studying the playbook of Volcker and Reagan, his
gaze rests on events 40 years earlier. Well-known to be a student of the
financial history the 1930s, Bernanke is well aware that when the same beast
raised its head following the Crash of 1929, the Fed rapidly raised interest
rates. His conclusion is that this over-reaction magnified the recession of
1930 into the Great Depression of the ensuing decade.
Scared stiff that these events could repeat themselves on his watch, Bernanke
is loath to push up rates. In this, he is ignoring the much more recent and
equally instructive lessons of the 1970s, in which a politically cowed Federal
Reserve stood by while inflation raged uncontrollably.
Across town, the stagflation reality is gradually dawning on Congress. But,
despite calls for higher interest rates from the likes of Mr Buffet and his
peers to strike at inflation first, the reality is that the powerful political
influence will be for lower interest rates and more government spending.
However, stagflation is not simply an American concern, and policy makers
around the world are showing that their priorities have not been similarly
realigned. As the Fed lowered rates to 2% over the past years, the European
Central Bank (ECB) has held firm. Given this difference in priorities, it
should come as no surprise that the dollar has plummeted to levels that draw
into question its privileged "reserve currency" status. The euro, in contrast,
has risen to heights that are now hurting European Union exports and causing
severe national political strains within the federation.
In this climate, all eyes were turned towards Frankfurt on July 3 for the ECB's
expected rate increase. Although ECB president Jean-Claude Trichet did deliver
the increase, he unexpectedly announced that the ECB was putting its series of
rate increases on hold. Why had Trichet suddenly gone weak in the knees? Had he
been influenced by Bernanke to abandon the Germanic bias to control inflation
and to adopt the acute Anglo-Saxon fear of recession?
If the ECB has thrown in the towel, stand by for lower rates, and intensified
inflation throughout the world. In the United States, hyper-inflation is a
distinct possibility. In such an environment, investors should think not only
of buying the financial "insurance" of gold but of devising ways to hang on to
it in the face of possible government confiscation, as happened in the 1930s.
Given Bernanke's reverence for the policies of the Franklin D Roosevelt era,
such a move is not beyond the realm of possibilities.
John Browne is senior market strategist, Euro Pacific Capital.
Euro Pacific Capital commentary and market news is available at http://www.europac.net.
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