Stag yes, flation no

Markets have rapidly moved towards our long held view that the global economy is slowing aggressively, and that recession is imminent (or already here) in the States. However it seems that the consensus is that this growth slowdown will be accompanied by strongly rising consumer prices – in other words stagflation. I don’t believe that’s likely. The consequence of a global banking crisis (and that’s what this is) is that liquidity is withdrawn from the system, and the availability of credit is significantly reduced – these are not inflationary outcomes. Here’s what happened to inflation in the aftermath of banking crises in the last century.

Banking Crisis – Change in inflation over next two years
Wall Street Crash (1929) – Fell from -1% to -10%
Savings & Loans (early 1980s)- Fell from 15% to 3%
Japanese bubble bursting (end 1980s) – Fell from 3.5% to 1%
Swedish Banking Crisis (early 1990s)- Fell from 10% to 2.5%
Asian Financial Crisis (1997)- Fell from 4.5% to 1% (Thai data as proxy)
Global Credit Crunch (2007-?) – ?

Sure, food prices are rising (and will stay high), and oil is $100 a barrel – but the key driver of inflation is the difference between actual growth and the economy’s potential growth. As the output gap opens up as growth slows, disinflationary pressure builds – there is overcapacity, and no supply of credit. With a combined share of around 15% of the inflation basket, higher food and energy prices will hurt consumers – badly – but unless they can negotiate higher wages in response (unlikely) they’ll have to reduce spending elsewhere. Thanks to the credit crunch, borrowing to finance discretionary spending will be more expensive and harder to find. Central banks need not worry about inflation – but they must stop the banking crisis from accelerating. Ben Bernanke knows this, and that’s why we could see a 1% Fed Funds rate later this year.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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