Is there going to be inflation or deflation in the future?
Good arguments can be made on both sides. In my opinion, though, the most likely scenario is stagflation – namely, slow economic growth accompanied by high inflation.
The latest numbers from the United States demonstrate these twin trends. While inflation has been rising in the last year or so, employment gains have halted.
Meanwhile, in Britain, consumer spending and economic growth have flattened, while the rate of inflation has hit new 52-week highs of more than 4 per cent a year.
Annual inflation across the 34-nation Organization for Economic Co-operation and Development jumped to 3.2 per cent in May, driven by the sharp acceleration of inflation in Canada and the United States. Note that this rising inflation took place in the face of slow economic growth.
If these trends continue, the future is going to look a lot like the 1970s. Events are consistent with my December, 2010, column, which concluded: "While the behaviour of real interest rates suggests that the economic outlook may look better in the U.S. than in Canada, my view is that it will not be characterized by vigour in either country and much of the growth will be inflationary."
The recent performance of real return bonds – which do well in times of stagflation because they provide protection against inflation in an economic environment that lacks real growth – demonstrate that many investors are seeing a return to a 1970s-style economy as a strong possibility. Real return bonds are up 6.4 per cent year-to-date in Canada, and have been one of the best performing investments over the last few months. The John Hancock real return bond fund in the U.S. has risen by a similar amount.
As the prices of real return bonds have risen, their yields have collapsed in both countries, to less than 1 per cent. In theory, this scant yield should be equal to what the markets expect real economic growth to be. It is much lower than the 3 per cent or so annual long-term growth rates that were considered normal in the past.
The view that the U.S. is headed into a period of slow growth finds support in The Great Stagnation, a book written by Tyler Cowen, who holds the Holbert C. Harris Chair in Economics at George Mason University. He argues that the U.S. has used up "the frontier, educated all of the farm kids and built a couple of cars for every family," and thus has exhausted all the easy sources of rapid growth.
The U.S. is a key consumer of what the world produces. If its growth rate is dwindling, this will significantly slow world economic growth.
The U.S. Federal Reserve keeps printing money in its efforts to spur economic growth. However, the expected expansion in bank lending has taken place not in the U.S. but rather in Asia and Latin America. This has had the effect of increasing money supply in other countries, creating inflation and bubbles around the world. Inflation has already fostered riots in North Africa and elsewhere. This is definitely not good for economic growth.
Are there wage pressures to justify persistently higher inflation? Workers have little bargaining power in Western countries due to high unemployment, but wages in Asian countries are increasing sharply. And these are the workers who produce goods for export to the rest of the world – so the prices of these goods are rising.
At the same time, Asian nations are rapidly moving from being producer countries to consuming countries as their citizens enter the middle class. Their new buying power will put upward pressure on prices. Asia has had a dampening effect on global inflation over the last decade; in the future, it will contribute to global inflation.
Normally, the Fed and other Western central banks would move to extinguish inflation by raising interest rates. This is no longer a viable strategy given high unemployment rates and turmoil in debt markets. Instead, the Fed is lowering interest rates by flooding the system with cash.
In the past, monetary authorities like the Fed could bank on a decelerating economy to stamp out inflation. But much of what is driving inflation nowadays is not linked to the U.S. economy. As in the '70s, this could turn into inflation and slow growth – in other words, stagflation.
In the U.S., consumer prices increased by 5.5 per cent in 1970 and peaked at 13.3 per cent in 1979. In the '70s as a whole, inflation rose by 7.4 per cent annually, up from 2.5 per cent a year in the '60s. At the same time, the economy grew by just 3.3 per cent between 1970 and 1979, much less than in earlier years.
In the years ahead, we will be lucky if we achieve even the growth rates reached in that earlier decade. The 1970s was not a great time for investors, particularly bond investors, who experienced negative real returns, and this will be the case in the 2010s.
George Athanassakos