Slowing Growth, Persistent Inflation

By Dr. Duru written for One-Twenty

July 28, 2006

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Since most people seem to believe stagflation is "impossible," I chose the title as I did: "Slowing Growth, Persistent Inflation." Consider it my euphemism...until inflation accelerates across the board...or something.

Anyway, I highly recommend those of you who are active in these mad markets keep tabs on the major economic reports. They actually mean a lot right now (I tend to ignore them in favor of watching stock market action). Recall that Bernanke surmised earlier that slowing economic growth should act as a break on inflation. Imagine the conundrum if inflation persists, or even accelerates, despite slower domestic growth? How could this happen? Hopefully, it is clear by now that oil could continue to rise in price regardless what the Fed does. I will reiterate that I suspect oil will soon correct when enough geo-political fears subside (or when the fears are so high that there is nowhere to go but down), but such a correction would be a buying opportunity in the oil patch. What intrigues me right now are the statements coming out of China. It seems the Chinese government is getting increasingly concerned that their economy is overheating as growth continues to soar and investment continues to boom. If the Chinese ever get successful at bringing the hammer down, presumably, they could sop up some excess manufacturing capacity that is helping to keep global prices down in manufactured goods. This should drive the prices of same goods higher. Counter-balancing that would be a decrease in demand for commodities. It is not clear to me which one wins, but I keep hearing that commodities are a small (negligible?) fraction of industrial costs now...does that only apply to the more developed economies of the world? I do not know yet. Chinese industrial labor can be bought for pennies on the dollar compared to the U.S.

Another factor in maintaining inflation as growth slows down could be persistent consumer spending. I have seen statistics that Americans have driven their net savings rates to zero now (see statistics compiled by the Federal Reserve - I hope to get more specific on this in the weeks to come). As long as the Asian countries who are accumulating savings (in U.S. dollars!) continue to risk their savings lending to us/U.S. consumers, we could see consumers amass even more debt to support our current expectations of living (I substituted "expectation" for "standard" on purpose - more on that to come as well). If the Chinese make their own domestic investment less attractive, perhaps investment in places like the U.S. could actually increase and increase competition for capital and/or resources here. Interesting thought. Anyway, I suppose there is no reason why consumer savings could not go net negative and stay that way for a short spell. Again, as long as the loans keep pouring in. Or maybe the Federal government could seek to cure the deficit by lowering taxes even more. That would put more money in the pockets of those who are paying the most in taxes...and slap the bill on future generations...again. How many more Fed rate increases will it take to stop the flow of funds? Apparently, the current levels are still not doing the job... (yes, I am suggesting that the Fed is NOT done hiking rates!)

The above is all speculation. What we do know right now is that the current data is telling us we are now in a period of slowing growth and persistent inflation. Whether this is a blip or not, time will tell. The housing market has decelerated and now outright slowed down. How much longer do you think it will take for other cyclicals to follow housing's heavy footsteps? The Nasdaq is certainly acting like the tech sector is next if it is not already there. Keep your eye on stumbling stocks like CAT, DE, and the like. You can expect the optimistis to pooh-pooh the numbers. The bears should be roaring ever more loudly. After reading "Empire of Debt," I am firmly in the bear camp on this one (I will be referring to this book more and more in my writings - stay tuned).

Just for good measure, here is my own selective summary of the numbers that got released today and how they influence my current thinking (much of this I pulled from a WSJ report posted today):

  1. 2nd quarter GDP increased only 2.5%, down from the 1st quarter's blistering 5.6% pace. Let's call it even for now. One number was abnormally high and the other may be abnormally low. The average consensus was for 3.2% which I think is the long-term average the economists like to shoot for. Regardless, the slow growth should appease those optimists who want to give the Fed reason to stop raising rates. They will focus on this one number and insist that a soft-landing is at hand.
  2. The PCE, which was Greenspan's favorite inflation indicator and I assume the Bernanke's as well, actually rose 2.9%. Jumping ahead of the previous quarter's 2.1% pace. Uh oh! Higher prices while the economy blipped downward!? Could it be? Stay tuned...
  3. In related numbers, the cost of labor went up again. Given I am also labor, I like to see this number go up (the salary component) and even the President will take heart. But the spectre of higher costs of employment spook the heck out of inflation watchers. Again, recall that labor represents the vast majority of all costs for employers. Given the increase was 0.6% in the first quarter and now 0.9% in the second quarter, we have yet another warning that inflation is on the creep (wages and salaries went up 0.9% and 0.7% respectively). And another warning that the Fed still has work to do in hiking rates!
  4. Residential fixed investment dropped 6.3% which apparently is the largest decline since 2000. We have all heard by now the big drops in sales numbers for housing (except for the stubborn West!) and Pulte's CEO recently ran down the well-worn litany of problems in the housing sector during his company's earnings report. This big drop in residential fixed investment is one more negative "building" against the consumer. Take this one seriously. We all know what happened after 2000...
  5. U.S exports actually increased 3.3%, ahead of the 0.2% increase in imports. This is the second quarter in a row where exports actually outpaced imports. While both numbers are a far cry lower than the first quarter's (recall the GDP differential), we should take pause whenever the trade numbers suggest some sort of competitive advantage for the U.S. I would like to know what it is we are exporting more of before I can comment further. I am also thinking currency differentials could be at work? Regardless, this is a small feather in the U.S. economy's cap.
All in all, I remain convinced that we need to take the stagflation, uh, I mean, slow growth, persistent inflation, scenario seriously. Finally, the numbers still tell me that The Fed still cannot stop hiking rates until the economy buckles. Stay tuned and be careful out there!

DrDuru, 2006