Supply Shocks and Stagflation

Box: Supply Shocks and Stagflation

If a supply shock is sufficiently large or persistent, it not only causes cost‑push inflation, but can noticeably reduce both the current and potential level of output in an economy. In this case, there can be the unusual combination of a period of ‘stagnation’ as output declines at the same time that prices are rising. This combination of stagnant growth – with high or rising unemployment – and high inflation is referred to as stagflation. Stagflation can become entrenched when inflation expectations are not well anchored.

The 1970s were a period of stagflation that featured two oil price shocks. In October 1973, the members of OPEC (the Organization of Petroleum Exporting Countries), as well as Egypt and Syria, imposed an oil embargo on industrial nations that had supported Israel in the Yom Kippur War of the same period. The embargo resulted in a quadrupling of oil prices and energy rationing, culminating in a global recession in which unemployment and inflation surged simultaneously. Central banks did not target inflation at this time, and this was the start of a prolonged period of high inflation in many economies.

https://www.rba.gov.au/education/resources/explainers/causes-of-inflation.html

A Primer On Inflation - Is Inflation always bad?

A Primer On Inflation

Inflation instantly brings to mind images of rising prices, shrinking paychecks and unhappy consumers, but is inflation all bad?

Inflation is defined as a "sustained increase in the general level of prices for goods and services." Many consumers fear inflation because it reduces the purchasing power of their money. The influence that inflation has on consumers in the United States and other developed nations can be seen in gasoline prices, to name one example. When the price of gasoline goes up, it costs you more money to fill up your vehicle at the gas pump. Although the amount of money allocated to fuel takes a bigger percentage of your paycheck, you get the same amount of gas. This hit to your bottom line leaves you with less money to spend on other items.

In less-developed countries, food price inflation is an ever-greater concern. When the price of basic food items increases significantly, low-income consumers experience severe hardships. In recent years, food price inflation has resulted in public demonstrations and rioting in numerous countries across the globe, including Chile, Morocco, Tunisia and Algeria.

Measuring Inflation
There are several ways to measure inflation. Headline inflation is the raw inflation figure as reported through the Consumer Price Index (CPI). The Bureau of Labor Statistics releases the CPI monthly. It calculates the cost to purchase a fixed basket of goods as a way of determining how much inflation is occurring in the broad economy as an annual percentage increase. For example, a headline inflation figure of 3% equates to a monthly rate that, if repeated for 12 months, would create 3% inflation for the year.

The headline inflation figure is not adjusted for seasonal changes in the economy or for the often-volatile elements of food and energy prices. Headline inflation is the measure that has the most meaning for consumers, as we have to eat food and fuel our cars.

Core inflation, which is the Federal Reserve's preferred yardstick, is a measure of inflation that excludes food and energy. Core inflation eliminates these items because they can have temporary price shocks that can diverge from the overall trend of inflation and give what the prognosticators at the Federal Reserve view as a false measure of inflation. Core inflation is most often calculated by taking the Consumer Price Index and excluding certain items (usually energy and food products). Other methods of calculation include the outliers method, which removes the products that have had the largest price changes. Core inflation is thought to be an indicator of underlying long-term inflation.

Several variations on inflation are also worth noting. Hyperinflation is unusually rapid inflation. In extreme cases, this can lead to the breakdown of a nation's monetary system. One of the most notable examples of hyperinflation occurred in Germany in 1923, when prices rose 2,500% in a single month.

Stagflation is the combination of high unemployment and economic stagnation with inflation. This happened in industrialized countries during the 1970s, when a bad economy was combined with OPEC raising oil prices.

At the other end of the spectrum is deflation, which occurs when the general level of prices is falling. This is the opposite of inflation.

The Good Side of Inflation
Inflation has such a negative connotation that many people fail to consider the good side of inflation. Yes, inflation means that it costs more money to purchase items that were previously available at a lower price. However, it can also mean that the prices of homes, precious metals, stocks, bonds and other assets are rising. For the owners of those assets, inflation can have a wealthbuilding effect. Inflation can also result in rising wages. If wages rise as quickly as the cost of goods and services, then the rising wages can offset the rising prices.

Monetary Policy
The United States, Great Britain and some other nations have set targets for the desired inflation rate. A January 2012 press release issued by the Federal Reserve's Federal Open Market Committee sums up the policy in the U.S. and highlights the reasons behind it.

"The inflation rate over the longer run is primarily determined by monetary policy, and hence, the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2%, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates, and enhancing the Committee's ability to promotemaximum employment in the face of significant economic disturbances."

That short paragraph sum up a complex and controversial set of issues. It starts with the Federal Reserve (Fed), the central bank in the U.S. and its dual objectives of maintaining a modest level of inflation and a low rate of unemployment. In order to achieve these objectives, the Fed controls monetary policy. The term "monetary policy" refers to the actions that the Federal Reserve undertakes to influence the amount of money and credit in the U.S. economy.

Changes to the amount of money and credit affect interest rates (the cost of credit) and the performance of the U.S. economy. To state this concept simply, if the cost of credit is reduced, more people and firms will borrow money and spend it, and this spending will then foster economic growth. Similarly, if interest rates increase, it costs more to borrow money. When this happens, fewer people and firms borrow money, which results in decreased spending and slower economic growth.

The Bottom Line
Putting it all together, the Fed uses its tools to control the supply of money to help stabilize the economy. When the economy is slumping, the Fed increases the supply of money to spur growth. This fuels inflation. Conversely, when inflation is threatening, the Fed reduces the risk by shrinking the supply. It all sounds simple enough until you view it in the context of the many other factors that influence the economy in the U.S. In this larger context, monetary policy, inflation and just about everything else associated with these topics become fodder for economists, politicians, academics and just about everyone else to discuss and debate.

http://www.investopedia.com/articles/economics/12/inflation-primer.asp#axzz2AmPnsMqp

US Debt Crisis (Video)

Inflation and Your Portfolio

Inflation’s Deflating Effect on Stocks
No Free Lunch With Looser Credit, Increased Government Spending

by Virginia B. Morris
13.5.2009


As unemployment increases and retail sales falter, the threat of inflation isn’t getting much attention. Instead, the government is focused on trying to stimulate spending as a way to end the recession. Using the primary tool at its disposal, the Federal Reserve has kept the federal funds rate between 0 percent and 0.25 percent since the end of 2008. By comparison, the rate was 5.25 percent in summer 2007, before the meltdown in the subprime mortgage market and the subsequent credit crisis.


Perhaps the most immediate effect of the Fed’s decision is the reduced rates on conventional mortgages available to borrowers with high credit scores. In many areas of the country, those rates are lower than they’ve been since 1965, according to Freddie Mac. Car dealers are offering even lower rates — though sometimes with strings attached — to get moribund vehicle sales moving.

But even with the added liquidity that low rates provide, there’s been relatively little economic growth. One reason is that people concerned about losing their jobs are reluctant to make major financial commitments, including
discretionary or large purchases. Similarly, businesses that may be able to borrow more cheaply, or hire talented workers more easily, than they could six months ago
may be reluctant to expand when the timeline for an economic recovery is uncertain.

Meanwhile, if the Fed’s looser credit policy works — and we have to hope it does — the downside is that it could kick off a new inflationary spiral.

The spiral typically works like this: On the consumer front, increasing demand for a range of products would drive prices up because months of production cuts have reduced supply. On the business side, the increased costs of adding new employees and new equipment to meet demand would result in higher prices for new products. More problematic, an expanding economy typically increases demand for energy, which can ratchet up costs across the board.

Inflation and Your Portfolio

As if paying more for almost everything weren’t enough, rising inflation can also create problems for your stock portfolio. An old rule of thumb is that when inflation threatens, stock prices suffer.

One explanation for falling stock prices in an inflationary period is that interest rates also often inflate as the Fed tightens the money supply to rein in borrowing. When the rate investors can earn on insured bank CDs is high enough, they tend to move out of stocks and into CDs. The thinking is that there’s no reason to risk losing principal when you can realize a higher return with no risk.

In addition, investors may be concerned that the higher earnings companies report in inflationary periods may result from artificially high prices rather than productivity gains. In that case, investors may be unwilling to pay the current price for the stock or, if they own it already, decide it’s time to sell. Similarly, if they sense that inflation is getting out of hand, they may anticipate that the Fed will reverse course and tighten its credit policy. In that case, companies that have become too dependent on easy credit are likely to lose traction as borrowing becomes more expensive. As their expectations falter, their stock prices are likely to fall.

The Deficit and Stock Prices

Another, more serious threat to stock prices may be the increased federal deficits that result from the programs designed to jump-start the economy and put more money into circulation. To meet its obligations, if the Treasury needs to raise rates on its issues to attract investors, those higher rates will attract money that might otherwise have gone into stocks, pushing equity prices lower.

At the same time, if unemployment remains high, the country could witness a replay of the stagflation — high inflation in a stagnant economy — that plagued the United States in the 1970s and early 1980s. In 1980, for example, the inflation rate topped 13 percent — more than 10 percentage points above the historical annual average of 3 percent.

Yet as concerned as stock investors may be about prospective inflation, it pays to remember that the early 1980s were followed by the longest bull market in U.S. history. Although this isn’t a prediction of what may happen over the next few years, history may provide some assurance that stocks have the potential to rebound even from the toughest times.



Virginia B. Morris is the Editorial Director for Lightbulb Press.

http://www.betterinvesting.org/Public/StartLearning/BI+Mag/Articles+Archives/060709abpublic.htm

Few assets benefit in stagflation

A combination of inflation and slow growth rarely helps any asset class. We had almost a decade of this in the 1970s, and stock and bonds suffered miserably. Even commodities struggled to rise in real terms.

1970s - a miserable decade

OPEC hit the world with two oil price increases. In 1973, the price per barrel went from a few dollars to over ten dollars, and in 1979 from the low teens to over 30 dollars. The west was far more dependent on oil than today.

The oil price fed into just about all prices, and inflation went out of control. By 1980, it was around 10%. People were accustomed to cycles in the economy. Normally, inflation would only rise when the economy was doing nicely and it was the excess demand that pushed up prices. However, in the 70s, jobs were scarce as unemployment also headed towards 10% and so there was plenty of unused capacity in the economy. This was inflation plus stagnation, and they had a nice word for it: stagflation.

No one knew what to do about stagflation. Australia tried wage freezes. Unions were more powerful then, and tried to ensure their members' wages were maintained. In the UK, they had 'the winter of discontent' and things became so bad that they were ready for the dose of medicine called Thatcherism.

No easy answer to stagflation

However, what could the authorities have done? A rise in the price of oil is like a tax on the entire country. Just about everyone is going to be worse off.

Unfortunately, there is no easy policy the authorities can adopt to fight stagflation. The economic theory has done a lot for economic management in normal conditions. The greatest economist ever, John Maynard Keynes, told us what to do: increase and decrease the government budget to smooth out the economic cycles. When people are not spending, governments should do the spending for them, and borrow the money. How insane were governments to reduce, rather than increase, government spending in the Great Depression! On the other hand, if people are spending too much and the economy is overheating, governments should cut back.

Keynes did not really trust interest rates as an economic tool. One reason was that in a recession, an interest rate cut may not be enough to encourage overly pessimistic consumers and businesses to borrow and spend. You can only lead a horse to water. But again, in normal conditions, interest rates can be used very effectively. When inflation rises, a little tightening up of interest rates slows things down a little, and the inflation eases off. This method of controlling the economy has become even more important as politicians have hijacked the fiscal budget for politics, rather than economics.

The trouble with stagflation is that the authorities don't know whether to boost the economy or to slow it down. Trying to create jobs risks even higher inflation, and trying to solve the inflation problem makes the job situation even worse. So it is not clear what to do with the budget balance or with interest rates.

These problems for the economy and the policy makers are reflected in the markets, and there is nothing attractive to investors. All you can do is to stay in cash, and to sell the other markets.

The stagflation of the 1970s only really ended when the US Federal Reserve gave the economy a sharp dose of very high interest rates in the early 1980s, and allowed a recession. Hopefully, we will not get another decade like the 70s for a long time.

Pick Your Poison: Inflation, Deflation, Stagflation

Active Investing: Managing Risk

Pick Your Poison: Inflation, Deflation, Stagflation

Lauren Young
Monday, April 27, 2009
EmailIMBookmarkdel.icio.usDigg

Analysts see possible scenarios for each of these to strike the U.S. economy. Stay alert and invest accordingly.

Will the real 'flation please stand up?

Experts are arguing about where the U.S. economy is heading as the global financial system tries to right itself. Is it on the path to inflation, deflation, or, worse, stagflation? Rising unemployment and excess production capacity are making it hard for the U.S. economy to climb out of recession. And that, in turn, is putting a strain on pricing power and wage growth—raising fears of deflation, which develops when a broad decline in prices amid falling demand feeds further price-cutting.

But what happens if the Federal Reserve's efforts to jump-start the economy take effect? Stimulus to the tune of $787 billion is supposed to rev up economic engines. Prices could climb too high as too much money chases after available goods and services—the classic formula for inflation.

"I describe [the potential dangers in] this economy in the form of a snowy Minnesota road," says Peter Rekstad, a financial adviser at TruNorth in Oakdale, Minn. "A car slid off the road into the deflation ditch. The way out of the ditch is to get a bunch of friends pushing while you rock the car back and forth. The big danger is that you get out of the deflation ditch and race across the road into the inflation ditch."

Or to take Rekstad's analogy further, say a car is straddling the road, with its wheels mired in both ditches at once—the worst of both worlds. That situation, where growth slows while inflation soars, is known as stagflation.

Here's an investor's guide to protecting your portfolio from these three forces.

Deflation

Deflation is the threat dominating headlines. "You've got a strong supply of goods and weak demand. That's a recipe for prolonged deflation," says A. Gary Shilling, economist and author of Deflation: How to Survive & Thrive in the Coming Wave of Deflation (McGraw-Hill). The problem is deflation's ripple effect: When banks stop lending, businesses stop expanding and wages fall. Consumers stop spending, which pushes prices lower. Why won't massive stimulus pull the economy out of the deflationary lane? Shilling fears that the U.S. government's economic tampering will have a "Big Brother effect," hurting innovation and permanently curbing growth.

The Signs. The surest sign of deflation is a decline in the consumer price index, which tracks the prices of consumer goods and services. But it's hard to ignore lower real estate values, which aren't in the CPI. Home prices fell more than 18% in 2008, according to the S&P/Case-Schiller U.S. National Home Price Index. Another deflation indicator: the higher savings rate, which we're seeing for the first time in 25 years. Shilling expects the savings rate to rise from 4.2% to 10% in the next decade.

Investment Strategy. "Quality is paramount in deflationary markets," Shilling says. He thinks most investors should be in short-term certificates of deposit or money-market funds. Those with a 10-year time horizon should also buy tech stocks, such as semiconductors, he says. Companies facing deflation can't cut prices and must boost productivity through technology.

Inflation

The Argument. Many of the economists and financial advisers polled by BusinessWeek for this story believe the huge amount of money being pumped into banks by the Federal Reserve (chart, right) makes inflation a real threat. Hans Olsen, chief investment officer for JPMorgan Chase (JPM)'s private wealth management business, says the stimulus plan ultimately will lead to higher inflation. However, total inflation is basically nonexistent at -0.4%. The trick is figuring out when it will be a problem. "The nasty thing about inflation is that it's insidious," Olsen says. Banishing inflation from the economy once it is "infected" is hard.

The Signs. The leading indicator used to measure inflation is the CPI.

Commodity prices, particularly those of oil and copper, are another bellwether. One indicator Olsen tracks is government debt as a percentage of gross domestic product, which he sees surging from 40% to 80% over the next few years.

Investment Strategy. Mild price inflation is considered healthy for stock investors because it is a sign that the economy is growing. But when inflation spikes, as it did when it hit 13% in the 1970s, interest rates rise and borrowing stops. For bondholders, soaring inflation eats away at asset values over extended periods.

The most direct way to fight this is to buy Treasury Inflation-Protected Securities (TIPS)—government-backed bonds pegged to inflation via the CPI. (TIPS belong in tax-deferred accounts because they are not tax-efficient.) A study by economic consultancy Peter L. Bernstein Inc. found that, for an aggressive investor who is worried about inflation, a 47%/53% proportion of TIPs to stocks (the study tracked broad stock market indexes) provided the best risk-adjusted real returns over a wide range of inflationary environments.

Among mutual funds, advisers favor the Vanguard Inflation-Protected Securities Fund (VIPSX), which had an annualized return of 5% for the past three years. Other plays include the iShares Barclays TIPS Bond exchange-traded fund (TIP) and Pimco Real Return Fund (PRTNX).

Commodities are another classic hedge. A well-diversified commodity play is the Pimco Commodity Real Return Fund (CRIX), which combines commodities with TIPS. Many advisers also like the SPDR Gold Trust ETF (GLD) and the First Eagle Gold Fund.

Stagflation

Stagflation is caused by the combination of slow growth and surging inflation. Slower growth will come from extreme caution by lenders, households, and businesses, while a shortage of production capacity will create inflationary bottlenecks, argues Mohamed El-Erian, chief executive officer at Pimco. "Stagflation will be part of the new normal," he says.

The Signs. The misery index, which combines the unemployment and inflation rates, is the best gauge of stagflation. In March it was at 8.1%. El-Erian predicts that unemployment will hit 10% by yearend, and 2% inflation could bring the misery index up to 12% by the end of 2010.

Investment Strategy. Insulating your portfolio from stagflation is tough. Equity investors need to take a very conservative stance, focusing on high-quality growth stocks such as Johnson & Johnson (JNJ) and PepsiCo (PEP), says John Boland, financial adviser at Maple Capital Management. Gold, as well as TIPS, will help mitigate some of the inflation risk. El-Erian considers TIPS a bargain because 10-year TIPS are pricing in inflation of less than 1.5% for the next decade, and he sees inflation jumping as high as 6% by 2011.

Young is a Personal Business editor for BusinessWeek

With Tara Kalwarski in New York

http://finance.yahoo.com/special-edition/active-investor/inflate-deflate-stagflate;_ylt=Apx_JUcYDM.BiqB1peaegXC7YWsA

Active Investing: Managing Risk
http://finance.yahoo.com/special-edition/active-investor;_ylt=Av0dbBsyTSeandibSloqvq67YWsA

What is the difference between inflation and stagflation?

What is the difference between inflation and stagflation?

Inflation is a term used by economists to define broad increases in prices. Inflation is the rate at which the price of goods and services in an economy increases. Inflation also can be defined as the rate at which purchasing power declines.

For example, if inflation is at 5% and you currently spend $100 per week on groceries, the following year you would need to spend $105 for the same amount of food.

Economic policy makers like the Federal Reserve maintain constant vigilance for signs of inflation. Policy makers do not want an inflation psychology to settle into the minds of consumers. In other words, policy makers do not want consumers to assume that prices always will go. Such beliefs lead to things like employees asking employers for higher wages to cover the increased costs of living, which strains employers and, therefore, the general economy.

Stagflation is a term used by economists to define an economy that has inflation, a slow or stagnant economic growth rate and a relatively high unemployment rate. Economic policy makers across the globe try to avoid stagflation at all costs.

With stagflation, a country's citizens are affected by high rates of inflation and unemployment. High unemployment rates further contribute to the slowdown of a country's economy, causing the economic growth rate to fluctuate no more than a single percentage point above or below a zero growth rate.

Stagflation was experienced globally by many countries during the 1970s when world oil prices rose sharply, leading to the birth of the Misery Index. The Misery Index, or the total of the inflation rate and the unemployment rate combined, functions as a rough gauge of how badly people feel during times of stagflation. The term was used often during the 1980 U.S. presidential race.

(To learn more about inflation and stagflation, see Stagflation, 1970s Style and Inflation: What Is Inflation?)

http://www.investopedia.com/ask/answers/09/inflation-vs-stagflation.asp?partner=NTU3