From Quantitative Easing To Stagflation?

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By Dian L. Chu, Economic Forecasts & Opinions

The United States economy grew at a sluggish annual rate of 2 percent in the third quarter, the Commerce Department reported last Friday. On the bright side, the economy is growing faster than the 1.7 percent growth in the second quarter and has registered the fifth straight quarter of expansion.

But here comes the dark side – the growth rate is far from sufficient to impact jobs. And the most disturbing piece of information is that the U.S. economy is still smaller than it was when the recession began--more than a year after the recession officially ended, which makes even a “jobless recovery” seem uncertain.  

QE - The Silver Bullet?

Doubts about the scale and effectiveness of an expected Federal Reserve second quantitative easing (QE2) has roiled financial markets of late. So, the latest dismal GDP data probably will cement an official kick-off of Fed’s buying long-term U.S. Treasury debt when they meet on Nov. 3.

However, will the long awaited QE2 be the silver bullet as the market expects?

90% Debt-to-GDP Threshold

As of October 10, 2010, the total public debt outstanding reached 94 percent of the annual GDP, and will be larger than U.S. GDP, around $14.2 trillion a year, in 2012, according to the International Monetary Fund (IMF).

Obviously, the U.S. debt level has already crossed the ominous 90% GDP threshold--part of the findings of a recent study published by C.M. Reinhart and Kenneth Rogoff. The two economists’ study on the relationship between debt and growth finds that when public debt exceeds the 90% threshold, a country's growth is significantly less--4% on average--than its lower debt counterparts.

That suggests the debt level of the United States seems to have reached a saturation point where more monetary easing would have very limited effect, and could even retard growth.

QE Unlikely to Cure Credit Crunch

Asset purchases by the central bank theoretically would push down real long-term interest rates and spur more lending, boost stock prices, and business confidence thus fueling growth.

However, we have learned from the first round of QE - record-low interest rates, and $2.05 trillion in securities holdings on Fed’s balance sheet, while benefiting the biggest U.S. companies, aren't trickling down to the smaller business—i.e. no spending, no hiring.

In the 12 months through August, banks pared commercial and industrial lending—loans typically used by companies without access to the bond market—by 11.3 percent. It is still under debate whether the decline is driven by the supply issue--the balance sheet constraints of lenders, or from the demand side--simply the lack of it.

Regardless, I believe the private lending decline seems mostly a manifestation--from both the supply and demand side--of business confidence lost, and the uncertainty over new regulatory rules.  QE2 along is unlikely to rectify, and thus would have limited positive impacts on the economy.

Where’s The Inflation?

There’s also a distinct risk of inflation associated with back-to-back QE’s on a global scale. I think the prevailing deflation fear is quite misguided, and the Fed could be caught ill-prepared when inflation erupts.

As the liquidity works through the system, the time lag between the increase in the money supply and inflation rate is generally 12 to 18 months. Typically, the following are two instances where more money printing would not turn into rampant consumer inflation

  • When the liquidity goes into creating asset bubble(s) (e.g. the Dot Com bubble, and the current U.S. bond bubble
  • Able to buy cheap imported goods to essentially export inflation

In addition, as describe in the previous “credit crunch” section, there’s a lot of the cash being held at banks to shore up their balance sheet, and corporations are also hoarding cash as ‘safety net” due to the gloomy and uncertain business climate.

So, these are some of the reasons that the U.S. has not seen much inflation spilling over to the consumer side yet, to the point that the policy makers are even having high anxiety over deflation.

Ripe for Stagflation

Well, heads up, Mr. Bernanke.

With wages rising in almost all low-cost exporting countries, it will become more difficult for the U.S. to contain inflation via cheap imports. Then, as more quantitative easing could further dilute the value of the dollar, pushing up the commodity prices, the system could be pushed beyond its limit into a possible “Demand-pull stagflation” scenario.

Stagflation is an economic situation when both the inflation rate and the unemployment rate are high. The demand-pull stagflation theory was first proposed in 1999 by Eduardo Loyo of Harvard University's John F. Kennedy School of Government.

This theory posits stagflation can result exclusively from monetary shocks, and describes a scenario where stagflation can occur following a period of monetary policy implementations that cause inflation.

Of course, there is also a scenario where high commodity prices, such as crude oil, tend to raise inflation while slow the economy, which is entirely plausible as well, based on the recent run-up of commodities.

A G20 Currency Showdown

The dollar-QE-induced inflation could also have global ramifications since China and many of the emerging and developing countries’ growth is highly dependent upon turning raw material into exportable goods.

China’s already on alert with newspapers quoting trade minister Chen Deming as saying

"Uncontrolled printing of dollars and rising international prices for commodities are causing an imported inflationary 'shock' for China and are a key factor behind increasing uncertainty."

And since dollar is still the major global reserve currency, QE2 could also decrease value of other countries’ foreign reserves.

As China most likely is not the only country sees the potential threat of QE2 coming out of the U.S., a big currency showdown in Seoul seems inevitable (resolution not expected) when the finance ministers from the G20 nations meet this month.  

Regarding Government Intervention

American business and people are resilient, tend to adapt, learn from mistakes fairly quickly, and probably could have worked its way out of this recession sooner without so much government intervention. That is--let the chips fall where they may--as capitalism mostly guarantees that nothing motivates and accelerates business changes more than losing billions of dollars.

Undeniably, government aid could help speed up a recovery after a massive crisis if it is done with proper priorities and implementations.  For instance, many have criticized China’s overbuilding “ghost towns” and asset bubbles in the aftermath of financial crisis.  However, my observation is that Beijing most likely is putting a priority on averting a nasty and prolonged recession by turning the entire nation into a gigantic construction site.   

From that perspective, China probably has done a better job than the U.S. although it is now left facing some of the consequences including escalating inflation, which ironically is part of what the Fed is trying to achieve through QE2.

Past U.S. Stagflation

Unfortunately, due to misguided policies and priorities, the U.S. has little to show for it despite a skyrocketing debt level after the crisis. And from what we discussed here, inflation through the printing press most likely will not translate into growth or jobs, and instead, has increased the odds of stagflation.

In case you are wondering when the last stagflation in the U.S. took place, the answer is the 1973–75 recession, inclusive of a stock market crash and the subsequent bear phase from 1973 to 1974. Inflation remained extremely high for the rest of the decade, while low economic growth characterized the next 20 years.

Investing for Stagflation

In this environment, hard assets/commodities (agriculture, energy, base metals, etc.) and commodity producers are likely to reign supreme. Equities in emerging economies would be the next best category.
Many mutual funds and ETFs such as Oppenheimer Real Asset Fund, PowerShares DB Agriculture (DBA), and Market Vectors Global Agribusiness (MOO) should give investors a broad range of selections in this category. .

Investment vehicles such as PIMCO Commodity RealReturn Strategy Fund that combine income and price appreciation also could protect from inflation with potential higher returns.

Meanwhile, gold bugs should send red roses to President Obama and Mr. Bernanke.

Dian L. Chu, Nov. 1, 2010