Stagflation is not a word that many readers would ever want to see again. But unfortunately it looks like the possibility of a period with rapid price increases coupled with anaemic growth could be upon us.
Certainly, inflation pressures have moderated after aggressively picking up in the first quarter of 2011. Morningstar's director of economic analysis, Bob Johnson, expects that moderating trend to continue in the months ahead; he thinks food prices are peaking and that pressure from high crude oil prices is easing.
However, it is quite possible that this trend will reverse again. A flare-up in Middle East tensions could send oil prices higher again, or an overly aggressive third round of quantitative easing from the Federal Reserve could spur inflation.
And consumers remain concerned about the possibility. The Reuters/University of Michigan consumer sentiment survey asks responders for their expectations for future inflation, and U.S. consumers are expecting a reasonably large hike in prices. For the next year, expectations indicate a 3.4% rise, and the five-year expectations are sitting at 3.0%.
A rise in inflation could have deleterious effects on growth and all sorts of issues that are important to investors. Below, I've highlighted three ways inflation could slow growth.
Central Banks’ Hands Get Tied
Many central banks, including the Fed, the Bank of England and the European Central Bank, have a dual mandate to keep price levels in check and seek maximum employment in the economy. A benign inflation number has allowed central banks in developed markets to focus exclusively on maximum employment since the start of the crisis. In the U.S., the Fed has been the primary driver of stimulative policy recently as Congress' appetite to pull the fiscal level has waned. Chairman Ben Bernanke took the federal-funds rate close to zero in 2008 and has kept it there since. The Fed has also pumped money into the economy through two rounds of quantitative easing and other programmes.
The aggressiveness of the Fed's response to the recession is a sign that it would rather err on the side of having too loose of a policy than one that is too tight. I personally think that Bernanke would love nothing more than to keep rates low until the recovery has truly and completely taken hold. In the U.K., inflation doves have also taken the upper hand in the Bank of England’s Monetary Policy Committee and, judging by the latest MPC minutes, inflation concerns are likely to be left on the back burner for now.
But if inflation starts to heat up, central bankers in London and Washington are going to have to start looking at the other side of the dual mandate. That means potentially raising rates in an attempt to keep price levels in line. This could have a negative impact on the still-fragile recovery on both sides of the Atlantic.
Certainly monetary policy eventually has to move on from these extraordinary levels, but it would be nice if it could happen on the central banks’ terms instead of Bernanke or Mervyn King being forced to act as a result of rising prices. Otherwise, there is a decent chance that either economy will be faced with a double whammy of high inflation and low growth.
Consumers Might Slow Down
More expensive products don't generally bring out consumers in droves. The consumer remains the key driver of the economy and a retrenchment in consumer spending could have very negative effects on growth. It's not like wages are rising fast enough to make up for higher prices. In fact, hourly wage growth has looked pretty poor as the slack employment market has made it easier for firms to avoid giving workers raises.
Emerging-markets consumers in particular will be some of the hardest hit by rising food and energy prices. A large share of consumers' budgets in emerging markets are allocated to basic needs such as food and heat. As it costs more to heat homes or feed families, there is even less to spend on other goods.
Emerging markets have been some of the strongest performers during the recovery, and many in developed markets were hoping that the consumers were ready to really open up their wallets and start spending. The basic idea was that higher spending would help boost exports from places like the United States and help ease global trade imbalances. These hopes look like they will be dashed if global inflation takes hold and emerging middle classes are forced to stop spending.
Margin Compression
Inflation isn't going to be good for the profitability of the vast majority of firms. Rising input costs wouldn't be a huge worry if firms were able to pass those higher prices along to consumers. Unfortunately, that could be very difficult in this environment. The consumer has come back but is still in a tenuous position and is hesitant to accept higher prices. Many firms might find that they have to eat most of the increase in costs which could mean a big hit to the bottom line. Corporate profitability has been a bright spot throughout the recovery, but a sharp reduction in profits won't help the recovery at all. It could lead to a reduction in corporate reinvestment and potentially make all sorts of firms more timid.
Of course the impact will be uneven across industries. Some, such as the airlines, could be hit especially hard as oil prices rise, while others with strong pricing power might be able to escape relatively unharmed.
Are you worried about the impact of inflation? Do you think inflation isn't coming at all? What industries will see the biggest impact? Are you making any changes in your portfolio? Please share your thoughts below.
A version of this article appeared March 31, 2011.
