The financial markets knee-jerk responses and falls are ignoring the evidence of stagflation

19th August 2011 by Shaun Richards

After a few days of relative calm in the world’s financial markets we saw them return to panic mode yesterday and at one point the US Dow Jones had fallen by 500 points. We ended with the German Dax down 5.8% and the UK FTSE 100 down 4.5% and the US S&P500 down 4.4%. This morning these falls have continued and the UK FTSE 100 has fallen below 5000 again. As a child I used to watch the programme Stingray which often used the phrase “In the next thirty minutes anything can happen” and if yesterday was any guide they were preparing me for adulthood quite well!

The causes

One of the causes is the general fear that has pervaded markets in recent times and the feeling that events have slipped out of control. This is combined with a rising number of demonstrations that the world’s political leaders are trapped in a repeating loop of errors.For example the Merkel/Sarkozy agreement of earlier this week announced a Tobin tax on financial transactions. It did not seem to occur to them that rather than stabilise matters it would destabilise the share prices of many banks. Because of its large investment banking operation Barclays in probably the UK bank most exposed to this and having hit a high of  188 pence on Monday it is now at 147 pence some 22% lower compared with 6% for the wider market.

Whilst you are mulling over the incompetence of what I have argued many times is in effect a rescue for the banking sector which has driven their shares down such examples are not confined to the Euro zone. President Obama annouced this week that he has plans for extra spending to help unemployment to which he can add deficit cuts. Sadly these days nobody is willing to even consider that he might have truly discovered the economic equivalent of the holy grail! In reality we all know what to expect which is extra spending now to be paid for by deficit cuts later which will be conveniently on another President’s watch.

The real problem for politician’s right now is that continued exposure to their plans has meant that their inadequacies have been highlighted. It is much easier to look intelligent in a bull market as mistakes are hidden by it. Whereas now markets are much more likely to respond with the equivalent of the football terrace chant “You don’t know what you are doing.”

To this general unease we found some specific factors added to it.

US economic figures: more evidence of stagflation

Firstly we found that something familiar had returned after a sadly brief delay when the Bureau of Labor Statistics told us this.

In the week ending August 13, the advance figure for seasonally adjusted initial claims was 408,000, an increase of 9,000 from the previous week’s revised figure of 399,000. The 4-week moving average was 402,500, a decrease of 3,500 from the previous week’s revised average of 406,000.

So we are back above 400,000 again and after the usual upwards revision last week’s number nearly made it too. This is now the best part of five months we have been above this number or in one instance only 1000 below it. There was a little ray of light from the fall in the four -week average but the US unemployment situation is plainly still troubled.

Then we got a shock number from the Phileadelphia Fed survey of regional conditions. It is not a first line indicator as it is only regional but the effect of what is highlighted below resonated.

The survey’s broadest measure of manufacturing conditions, the diffusion index of current activity, decreased from a slightly positive reading of 3.2 in July to -30.7 in August. The index is now at its lowest level since March 2009.

I think that markets saw the drop in the index combined with the phrase lowest since March 2009 and simply panicked. However if we consider the situation logically what we see if we take both figures we see that there was yet more evidence of a US economic slowdown to add to what we have already seen. Indeed as a man who has argued that we are seeing stagflation we then got some more evidence establishing this but this time, and I will explain why I think this happened in a moment, this evidence was ignored.

US Consumer Price Inflation

The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.5 percent in July on a seasonally adjusted basis….. Over the last 12 months, the all items index increased 3.6 percent before seasonal adjustment.

So consumer inflation is rising and if we look at producer prices for which we received new data earlier in the week we saw this.

On an unadjusted basis, prices for finished goods moved up 7.2 percent for the 12 months ended July 2011…………On a 12-month basis, the index for intermediate goods climbed 11.6 percent.

So there you have it about as clear a definition of stagflation as you are likely to ever get! In the market melee many are ignoring this and this is leading to the wrong conclusions being drawn I think. One of the features of any slowdown in the credit crunch seems to be that  we immediately assume we are going to collapse and fall off the edge of a cliff and many seem unable to get past this particular “thought-bubble”. Many official bodies encouraged this with apocalyptic (and at the time incorrect views) claims of deflation fears to justify their use of extraordinary monetary measures and the fear this created may be one of the things which will undo all the money they have spent. I am no psychologist but I am aware it is a short journey from arrogance and hyperbole to panic.

There is also another factor which has come into play in recent times which goes as follows. You look at a rise in an inflation index and say that it is okay because a certain component went up. For example the US figures above had some discussing the rise in the price of coffee and tobacco respectively. Apparently they seem to think that inflation can rise without any price rising!

Evidence of this?

I wrote only yesterday about bond yields and how low they had become. Well this trend surged forwards yesterday such that the US ten-year or Treasury Note yield went briefly below 2%. I would like you to look again at the inflation numbers above again if you would be so kind and consider the yield again. For this yield to have value over the ten years inflation would have to absolutely collapse from its current levels. Whereas in reality we are looking at a probable dip in it but a collapse? We certainly do not know that.

The Swiss National Bank borrows from the US Federal Reserve

I am grateful to Mr.K for drawing my attention to this. It adds to the dollar borrowing under the aegis of the European Central Bank I discussed yesterday. However this indicates a deeper malaise to my mind. We know that certain Euro zone banks are feeling the strain as for example Italian banks doubled their borrowing from the ECB in July but Swiss ones? As we consider that we have spent 2011 with foreign exchange markets trying to force US dollars ( and Euros and Pounds) on the Swiss it seems even odder that a Swiss bank needed US $200 million. Surely the Swiss National Bank could have helped itself……


So my thought for the day is that like the UK the United States has economic figures that apart from a sort of mass delusion which has overtaken commentators would be generally acknowledged as stagflation. There are certainly events happening right now which sem likely to reduce inflationary pressure but certainly not enough to justify such matters as current bond yields and accordingly I think that we can give them bubble status. Of course another bubble is exactly what we do not need.

UK Public Finances show signs of an improvement

So far in this fiscal year we had until this months figures seen little sign of the UK governments “hairshirt” of austerity actually having any impact. Spending had been rising as fast as tax income. However fortunately July’s figures show a reduction in spending growth which is 3.2% for the fiscal year so far including July but only 1.8% in July itself. So some evidence of improvement there which led to these figures today.

public sector net borrowing was -£2.0 billion; this is £3.4 billion lower net borrowing than in July 2010, when net borrowing was £1.4 billion; public sector net debt at the end of July 2011 was £2266.3 billion (148.0 per cent of GDP). This compares to £2175.6 billion(149.1 per cent of GDP) as at the end of July 2010

So we see an improvement in our fiscal deficit and also in our net national debt which comes as something of a relief. Whilst we are not actually cutting public spending (as many media organisations persist in claiming) we have reduced its rate of growth.

For new readers you may be surprised to see me quotes figures with financial interventions. I have followed these because we have them! It is my contention that if you report the numbers without them you are misleading people, although it is convenient as you have to look a long way down the report to find them! Let me put this another way with Lloyds at 28 pence and RBS at 21 pence as I type this the UK ownership of these banks is looking more permanent than temporary right now. Where are all thsoe who only a few short months ago were telling us we would be able to sell them off at a profit this summer? Group-think again?

32 thoughts on “The financial markets knee-jerk responses and falls are ignoring the evidence of stagflation”

  1. Anonymous says:

    I’m as baffled as I was four years ago about how we get out of this.  Whatever combination of policies is used I can only see a very long period of dislocation and suffering.

  2. graeme_b says:

    swiss 10 yr under japanese 10 yr – not sure what it means, but it can’t be good …

    1. Anonymous says:

      Thanks for reminding me of this. It has been quite a fall for the Swiss ten-year benchmark which a month or so ago was around 1.4%……

  3. Norwegian says:

    What would be your view on theories about possible hyperinflation in the US, as expressed for example by John Williams of Noticed that you qouted his alternative numbers recently.

    It seems logical to me that questions about the US long term prospects on top of additional QE could hurt market confidence in the dollar. There are quite a lot of $ outside of the US. What would stop inflation from running away in the US?

    1. graeme_b says:

      I am currently reading Adam Fergusson’s “When Money Dies” which describes the Weimar hyperinflation. So far my take on it is that for hyperinflation you need: 1) sustained monetization of government debt (Weimar saw ~1/2 government spending financed this way for several years); 2) a currency crisis versus external currencies; and 3) rampant speculation and a flight to real assets to get velocity of “money” going. At the moment the West’s situation doesn’t look so bad, but we’re getting there I think.
      Two other points worth noting are that there was an awareness at the time that ending the crisis would be bad for big business and employment, and so no politician was prepared to do so. Secondly, the crisis completely wiped out the wealth of the middle class and retirees, who were slow to react and believed for a long time that there would be a recovery and a return to normality. 
      It’s definitely an interesting read.

      1. James says:

        I too have read this amazing book. Since you like that sort of thing, let me quote from Winston Churchill’s history of World War two, which starts with an analysis of the pre-war depression and was published in 1948. You may find certain parallels with today:
        “The year 1929 reached almost the end of its third quarter under the promise and appearance of increasing prosperity, particularly in the USA. Extraordinary optimism sustained an orgy of speculation. Books were written to prove that economic crisis was a phase which expanding business organisation and science had at last mastered.”We are apparently finished and done with economic cycles as we have known them” said the president of the New York Stock Exchange in September (1929). But in October a sudden and violent tempest swept over Wall Street. The intervention of the most powerful agencies failed to stem the tide of panic sales. A group of banks constituted a milliard-dollar pool to maintain and stabilise the market. All was vain.The whole wealth so swiftly gathered in the paper values of previous years vanished. The prosperity of millions of American homes had grown upon a gigantic structure of inflated credit, now suddenly proved phantom. Apart from the nationwide speculation in shares which even the most famous banks had encouraged by easy loans, a vast system of purchase by instalment of houses, furniture, cars and numberless kinds of household conveniences and indulgences had grown up. All now fell together. The mighty production plants were thrown into confusion…20000 local banks suspended payment (in the USA). The means of exchange of goods and services between man and man was smitten to the ground and the crash on Wall St reverberated in modest and rich households alike.It should not however be supposed that the fair vision of far greater wealth and comfort ever more widely shared which had entranced the people of the USA had nothing behind it but delusion and market frenzy. Never before had such immense quantities of goods of all kinds been produced, shared and exchanged in any society…This splendid manifestation had been shattered and cast down by vain imaginative processes and greed of gain which far outstripped the great achievement itself.”The coincidences are amazing, I think. If only some of our politicians, MPC members, bankers and economists had read history rather than PPE and economics, we might not be in this mess….

        1. Alex Eames says:

          Sounds like the same thing happening all over again. That applies to graeme_b’s post as well. Both sound remarkably familiar. :(

      2. The most important part of the Weimar hyperinflation was the occupation of the Ruhr and subsequent stop in production. The German government nevertheless kept paying the workers to sit idle. Weimar and Zimbabue hyperinflation are a result of a huge decline in production capacity. If you lower an economy’s potential output by a large percentage and keep spending as usual you are bound to get hyperinflation. It’s not a monetary phenomenon it’s a production phenomenon.

        1. graeme_b says:

          Kostas: inflation is caused by too much “money” chasing too few goods and services, and this almost always comes about as a consequence of uncontrolled expansion of the money supply (am not aware of a counter-example). An important consideration in Weimar Germany’s case was that the government was unable and/or unwilling to raise enough money by taxation to pay its domestic and reparation bills, and so it printed the difference. Lack of confidence in the German currency meant that any sent abroad rapidly found its way back home and was redeemed for real German goods, leading to inflation and shortages. Sure, occupation of the Ruhr didn’t help matters, but I think it is wrong to cite this as the most important issue.
          Getting back to the developed world’s current situation, there seem to be two important differences. Firstly, there is much less external demand to keep industry going and aid speculative investments; and secondly, external references and alternatives to our currencies are less obvious (other than gold etc. of course), so it may take longer for real currency crises and dumping to get going. If you see continued large-scale “QE” and associated rapid appreciation of the surplus nations’ currencies, i.e. China, OPEC and Germany (sic), then watch out!

          1. Total rejection of currency cannot happen easily without a simultaneous collapse of production capacity. As for too much money chasing too few goods (more or less the monetarists view) it revolves around certain assumptions on MV = PY, mainly that V is constant (it isn’t) and Y is at full employment (it clearly isn’t).

             We have to distinguish between the money supply which is controlled by private sector credit expansion/contraction plus the government budget deficit/surplus with the monetary base which can be controlled by the central bank. QE changes the monetary base, not the money supply. Banks were never reserve constrained in their loaning decisions so (as long as IOR is paid) they are indifferent to the amount of excess reserves that they are holding. QE works as a tax on the banks balance sheets (replacing a high interest security with a low interest excess reserve), it does not alter lending ability and decisions.

        2. Anonymous says:

          The decline in production capacity is not necessary, government overspending alone can cause hyper inflation. Argentina is an example of excessive spending.

          1. If the government deficit spends far more than the full employment productive capacity of the economy it can create hyperinflation. There’s not real reason for it to do such a thing though.

    2. Anonymous says:

      Hi Norwegian and welcome to my part of the blogosphere.

      I do quote John Williams from time to time as the topic of inflation and indeed how you get their from prices and the problems with even determining a price these days is one of my topics. Back in 2009 I started with that sort of thing and would be on the subject more if so much else would stop happening! But returning to Mr. Williams he has obviously put a lot of thought and effort into work which challenges US inflation data and deserves respect for so doing…

      I see you have had plenty of quality replies ( a strength of this blog so please keep them coming) already but will add from my viewpoint that I never thought that the current forays into extraordinary monetary policies would lead to hyper-inflation however as I have replied before there are dangers with QE3 (I am using America as the template here) and QE4. In case you wonder why I also say QE4 if we get QE3 I think QE4 is likely to come along quite quickly.

      On this subject let me ask an open question. I plan to put some time aside to write some guides to particular topics and plan to do QE as a topic and also credit default swaps (which has been requested..) does anybody have other requests for topics or sub-topics?

      1. shtove says:

        One question that bugs me is whether QE has fed into commodity price rises. I’m sure it has, but can’t see the mechanism.

      2. Makfu says:

        Hi Shaun, 

        I wouldn’t mind if you did an article on which countries would be safe-havens right now to transfer fnds out of dollar, euros or pounds.  Particularly interested in Norway and others which are seen as safe-havens.
        It’s not easy to do this believe it or not, I’m finding

  4. “In reality we all know what to expect which is extra spending now to be
    paid for by deficit cuts later which will be conveniently on another
    President’s watch.”

    The US is the sole issuer of the dollar. There’s no real validity on the above sentence.

    As for the CPI, the major parts are energy and food prices (the second is deeply connected with the first). A slowdown in the US and the global economy will definitely push energy prices down just as it did in the second half of 2008. I really cannot understand how you come to a conclusion of stagflation in the current economic environment.

    1. Anonymous says:

      Hi Kostas

      I am unclear as to the link you express between the US dollars reserve status and an ability to borrow as much as they like. If so why do they bother with a debt ceiling?

      With my blog title of notayesmanseconomics I apply the rules to others and so there is no reason to agree with me if you do not want to!  I am familiar with that I was rather alone back in late 2009 when I started this blog with the warning that the UK was in danger of an inflationary push….

      1. Hi Shaun. I do not consider the dollar reserve status as relevant (in the sense that foreign government bond purchases are the direct result of the US running a current account deficit which allows the rest of the world to net save in US dollars). What is relevant is that the US dollar is a fiat currency with a flexible exchange rate issued by the consolidated US Treasury + Fed. Bond issuance is mainly a way for the Fed to keep control over the federal funds rate (as is IOR). The US could just do platinum coin minting, have an overdraft in the Treasury General Account or have the Fed buy it’s bonds and then provide IOR on the excess reserves created in the banking sector. The debt ceiling is a relic of the gold standard era. It ‘s rather fullish in the first place since it places a limit on already voted government deficit spending.

        I truly don’t mind disagreeing :) I just don’t see how a huge household debt deleveraging and increase in saving, a stagnant real worker compensation (especially in comparison with huge increases in the real output per hour) and general deflationary forces can coincide with a fear of stagflation (i am mainly painting the US economy status here, if we take the European economy into account it all starts to get very black).

        Inflationary forces are mostly an outcome of energy prices, either directly or indirectly through food. Zero or negative economic growth will just drive those energy prices down as well. In any case central bank interest policy cannot have any effect on the Saudi Arabia oil production, only on the domestic economy aggregate demand. If large energy prices are permanent we ‘ll have to live with that and try to increase the economy’s energy efficiency.

        1. shtove says:

          I incline to this view as well.

          Another way of putting it – the market in US bonds is right!

  5. Anonymous says:

    By the way, Stingray was one of my favourite programmes also (was on Greek TV).

    1. Anonymous says:

      I confess completely to a childhood influenced by Stingray,Thunderbirds and Captain Scarlet! One area where they do translate into modern times is the way that if a bridge is presented as invulnerable it invariably fell down. Many aspects of what was perceived as central economic thought have taken the same journey……

  6. Anonymous says:

    Hi Shaun
    I’m just wondering about the criticism of politicians / policy makers being incompetent. Should’nt  we be careful to distinguish between 1) central bankers and regulators 2) politicians. I accept that one is advised or guided by the other but is it fair to lump all accusations of incompetence on elected politicians. My view is that the real criticism should be made of what Mr Peston describes the ‘ high priesthood’ of top financiers, central bankers and regulators whose tools of trade and working capital are the markets and financial stability. Your accusation of incompetence appears sometimes to come from the markets’ perspective – politicians are not doing what markets want ie have their losses socialised constantly and environment feather-bedded and are therefore incompetent ( Eurozone response etc) – why should politicians bend to that agenda anymore?
    Paul Mason’s recent piece on what to do if the double-dip is real is a good one and directed me to read Haldane’s Risk On speech. He makes important points in relation to tackling the over-correction in pricing risk and tackling the damaged psychology which will dog markets since Lehmans and its fallout.

    1. Anonymous says:

      Hi Shire

      Reading your reply on politician’s has made me think that my paragraph on the subject does not fully express my views so let me have another go!

      I do blame our politician’s for the “kicking the can down the road” strategy at least partly as it suits them to move problems onto the next administration and I do blame them for knee-jerk responses to problems. However I do not blame them for the way many responses have been misconceived such as the EFSF because if we take that specific instance the ECB should have and must have seen the problems…

      Joe Stiglitz wrote recently that central banks were likely to suffer from “institutional capture” by the banks which of course is very similar to my theme that they are no longer independent. I would take that one step further and say that on the post credit crunch results our politician’s have suffered from “institutional capture” too.

      However if I have given the impression that I feel that politician’s and central banks should in general do what the markets want then I can only apologise for not expressing myself properly as I am not a fan of socialising losses at all and feel that many bankers should have been punished rather than rewarded….

      As to Andy Haldane’s paper it is a refreshing one in many respects. But if we take an overview the Bank of England has pressed for more regulation and banks to have more capital and if it adopts his policy then it is exhibiting my view of regulation, which is that it tends to bend like a jellyfish and accordingly is doomed to failure.

      As to Paul Mason I found this bit “Free market economics caused the crisis” to be rather sweeping and something which ignores the “crony capitalism” of the pre credit crunch era and the consequences of such things as the Bernanke Put and Too Big to Fail….I did send him on twitter a link to my post of today as it would be interesting to have a debate along those lines…

      1. Anonymous says:

        Hi Shaun – I am with you on the bombastic claims of shock and awe and doing ” what’s necessary” to preserve the Euro ; here politicians can be nailed. But, take Eurobonds – why should the markets expect collective indemnification when the SMP is already a bail-out ( your point) giving way to the EFSF. I just wonder whether the markets exploit the bombast to achieve socialisation/indemnification of losses in the same way they will egg the Fed on to QE 3.

        I agree on the sweeping ” free market caused the crisis” point.Financial markets were never intended to be free of state regulation. It excuses the army of Tripartite regulators and so-called financial regulation gurus who were paid handsomely to patrol and protect the system.I want to see a public inquiry on the failure of regulation so that we can find out between the High Priesthood and politicians as to who knew what and when. Hyun Song Shin was certainly running up the red flag on balance sheet risks of securitisation well in advance. Full publication in the UK of the Tripartite Authority minutes and agendas will be a good starting point, The Treasury Committee and House of Lords Econimc Affairs committees have only gone so far….

        1. Anonymous says:

          As political perspective is creeping in anyway:
          this latest top-level diplomatic fudge

  7. Anonymous says:

    In my opinion, the heart of the problem lies on the decision of politicians back in 2008 to save bankers and private investors and pass the debt to tax payers. This was not followed by a necessary and radical change of the rules of the global capitalist game. Everything else follows almost as a mathematical consequence. The bail outs of PIGS is the continuation of this policy. Huge moral risks and bankers et al. continue their profitable game with the expectation that people will bail them out. They care only for their bonuses. Pure greed. This will end in tears, people will revolt. The politicians represent the people and they should declare a war against the bankers et al. hit them hard where they will feel the pain, cut their bonuses completely and everywhere in the world. Otherwise it is a huge injustice to people who have now to face unemployement, cut in salaries, in services. There is no excuse to leave this corrupt lot to profit endlessly from gambling without consequences. The people want to see justice.

  8. Shaun.. a question. One of our better commentators here says he expects Fed swap lines to be re-opened to ECB. My question is.. isn’t this already the case ? I thought they did this in May 2010’s Greek crisis… or no ? Here’s the article I’m referencing, and his comments on SocGen in particular:

    1. Anonymous says:

      Hi Mr.K

      I think that he must mean actually using them. The lines themselves were recently re-opened until August 2012…

      “These operations will continue to take the form of repurchase operations against eligible collateral and will be carried out as fixed rate tenders with full allotment.”

      There is no limit stated and it goes out of its way to say full allotment…

      1. Isn’t it the ECB that needs to initiate their use ? 

        1. Anonymous says:

          Yes it would be the ECB that deals with the relevent European bank or Bank of England with the British one.

          Also just to correct my earlier reply whilst the ECB and Bank of England imply an open-ended commitment there is a limit and I plan to post on this in more detail…. I had wondered about the consequences of letting another central bank have control over your money supply so I searched again.

  9. Anonymous says:

    A view on the political folly around the Greek “rescue”:

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