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Central Banks Facing Stagflation - Bullish Gold, Currencies and Crude Oil

Economics / Inflation Jan 10, 2008 - 11:50 AM GMT

By: Christopher_Laird

Economics

Best Financial Markets Analysis ArticleOne of the main reasons gold is rising so much now is because central banks are facing stagflationary forces. Stagflation is a combination of economic stagnation with inflation. Central banks find it hard to lower interest rates because of inflation, and economic stagnation causes them to want to lower interest rates. This is very gold and oil bullish.

Many of the causes of gold's rise in the late 70's and 1980 are with us today. But let's first define stagflation:


“Stagflation, a portmanteau of the words stagnation and inflation, is a term in general use within modern macroeconomics used to describe a period of out-of-control price inflation combined with slow-to-no output growth, rising unemployment, and eventually recession. The term stagflation is generally attributed to United Kingdom Chancellor of the Exchequer, Iain MacLeod in a speech to parliament in 1965.[1][2] "Stag" is drawn from the first syllable of "stagnation", a reference to a sluggish economy, while "flation" is drawn from the second and third syllables of "inflation"--a reference to an upward spiral in consumer prices.

Stagflation becomes a dilemma for monetary policy when policies usually thought to increase economic growth will further increase runaway inflation while policies thought to fight inflation will further the decline of an already-declining economy…” Wikipedia.com

Our present CB stagflation dilemma

Right now, Central banks are caught with the dilemma of needing to lower interest rates to combat an emerging recession in the West, the US and EU. But this comes at a time when there are high oil and food prices. Other measures of inflation are also rising, and the US is flirting with an official inflation rate of 4%. Actual inflation is considered much higher by the majority of people in the economy. 
The point of higher actual inflation, and wage growth in the actual economy is creating inflationary forces which can only be combated by increased interest rates. Since the Central banks in the EU and US find that impossible to do now due to things like the housing and credit crisis, it is likely that inflation will remain an issue, even if there is a mild economic contraction. A serious contraction is a different issue, but we will discuss that in a moment.

In stagflation, there is a combination of economic ‘stagnation' where incomes stop growing, but prices rise and result in a net drop in consumer discretionary spending, as they get squeezed. A cycle of economic flattening, amidst rising prices causes a feedback loop as rising prices pressure consumers, and even if their incomes rise a bit, rising prices pressure consumers and cause them to pull back net real spending. If inflation is not driven from the system, a feedback loop of inflation and stagnant consumer income prevents economic growth, but prices continue rising.

Because central banks cannot increase interest rates due to economic weakness, inflation remains if there is not a serious economic contraction.

Therefore, the CB desire to avoid a deep recession, keep interest rates low prevents enough slowing and inflation becomes persistent. The only way to avoid this outcome is to raise interest rates enough to cause a rather deep recession. Volker did this to stop the out of control inflation/stagflation in the US in the 80s and raised interest rates drastically.

Of course, there is now so much debt accumulated in the West in all sectors that permitting the deep recession needed to purge inflation becomes politically intolerable, as mass defaults on debts and bankruptcies and so on are inevitable. If CBs don't allow a serious recession, we get stagflation.
The US Fed and the ECB may be faced with the choice of raising interest rates and biting the serious recession bullet, or face ongoing and painful stagflation.

Gold

Gold rises in persistently inflationary environments, and the fact that gold is at a nominal high now in the $880 range suggests that gold perceives inflation as an ongoing threat.

This has significant implications for the midterm prospects of gold prices – in the next year or two. It would seem that Central banks are going to be forced to lower interest rates. Already the UK, US and so on are cutting. The EU is expected to have to follow with cuts for several reasons. For one thing, there are indications of some significant reductions in consumer spending in the EU now.

Another reason the EU is going to be forced to cut is that they cannot tolerate further rises in the Euro VS the USD and other currencies pegged to the dollar such as the Chinese Yuan/RMB. EU exports are already being significantly pressured by a weaker USD and the Chinese Yuan pegged (effectively) to the USD.

In addition, rising oil prices are some of the most inflationary forces, as oil is used both the manufacture and transport just about everything, not to mention it is economies primary energy source, and is a mandatory expense just to live.

If things remain as they are now, stagflation remains with us and gold and oil rise dramatically.
1970s Stagflation compared to today

Now that we covered the general stagflation dilemma CBs now face, let's get to some comparisons with the radical gold market of the stagflationary 1970s.

First, we have to point out that we are early in this stagflation. Even though the gold price now is at nominal record prices at $880, if adjusted for the fall in value of the USD since 1980, I estimate the actual gold price now in 1980 dollars to be about $293. I come to this value by comparing a number of prices now vs then. If you take autos, houses, food, and the minimum wage then compared to today, you find they are at least 3 times higher. To get the 1980 USD price of gold now, divide the present $880 price by 3.

Oil is also higher in price. However, the $100 oil price today is actually roughly $33 in 1980 dollars. It has also been shown that people spent about 6% of their income on fuel in the late 70s -1980 vs 4% now, which would explain why people are coping with gas prices in the $3 plus range now. But there are signs that people are finally reacting to rising fuel prices.

Nevertheless, gold is not anywhere near its real highs in price reached back then. For gold to reflect that real level of cost, it would have to be well over $2400 (1980s high times 3). You can imagine how people would react to that now, they would be panicking. As it is, the general public is only barely noticing gold now, which shows just how far the gold market has to go up in the next two years if stagflationary forces are not culled immediately.

Can CBs raise interest rates to combat stagflation?

The odds of central banks actually raising interest rates in 08 and 09 appear very slim. They are more concerned about things like the credit/financial crisis, prospects of crashing stock markets, collapsing housing. They will cut, not raise interest rates in the next year or two.

This means stagflation will likely remain with us. There is a major qualifier to this however, and that is if we get a severe recession. This can easily happen if the credit/banking crisis combined with a collapsing Western housing market causes economic contraction. If we get actual serious economic contraction, then stagflation gives way to actual recession. Inflation will then start to disappear. Gold and oil would reflect this by either dropping in price, or just leveling out. Gold might continue way up if Central banks panicked and tried dropping interest rates radically to combat deflation, as in 2001/2.
Stagflation wins for now

As far as gold's judgment now, stagflation appears to be the winner. Gold thinks central banks are going to cut, going to flood out money to combat a recession and the credit crisis, and try like hell to avoid any meaningful recession. Inflation is a problem in the EU and US, and in fact is a worldwide problem now anyway. If we get stagflation, cutting interest rates is exactly the wrong thing to do.
China is flirting with 8% inflation, the EU 3%, the US nominally 4% but more like 8% in reality. The Mid East, India and other areas are already flirting with 8% and more inflation. Nations with large poor populations are having food shortages and big price hikes that are causing turmoil, and is a big worry. China figures here prominently, with food panics over shortages of cooking oil and rising pork and other food prices.

If central banks get their wish for at least an economic horizontal, instead of a serious recession, then inflation is in gear, and we get horizontal growth and inflation – stagflation.

Gold only beginning on this run if stagflation remains

But getting back to gold. Since gold is quite early in a bullish phase reacting to stagflation forces, if these are not checked, we indeed might see $2000 gold in a year or two.
A possible severe world recession would likely check this. I am not sure if Central banks can achieve a goal of economic horizontal (instead of a bad recession now). I'm not sure they want that as an outcome anyway. They know full well that if stagflation persists, that gold and oil prices are going to go out of sight. Heck, we already have oil analysts talking about $150 oil, and gold analysts talking thousand dollar plus prices. 

Currency realignment if stagflation

That is not to say that the currency realignments that would happen if gold and oil went out of sight would not be welcome. IF the USD were to devalue significantly, it is possible that the US might have a chance to export its way out of some of its economic problems. But the trouble with that scenario is that the EU cannot tolerate any further weakening of the USD to the Euro. And the relative weakening of the Yuan to the Euro would cause lots of pain in the EU if the USD fell much further, as I mentioned, the Yuan is effectively pegged to the USD. If the USD falls, the Yuan effectively weakens and the EU cannot tolerate further weakness to the Yuan/Euro or face further trade imbalances with China. In any of these cases inflation is rampant in the US and China.

But if the USD is allowed to weaken further, which is needed to assist its exports, then interest rates have to stay down, and stagflation will remain.

So, absent a major world stock sell off and recession, stagflation is with us, and gold and oil are reflecting this in their prices. But, as I said, remember that we are still very early in this gold bull market in real terms, as inflation adjusted gold prices are really about $293 in 1980 dollars.

Caution warranted for commodities, oil and gold

Even though gold and oil are rising and reflecting inflation and or stagflation now, there are serious cautions to remember. It is not clear that we will persist either in world economic growth and inflation, get stagflation, which is worse and more gold bullish, or fall into a severe world recession.

If we stay with decent world growth and inflation, gold and oil continue rising. If we get stagflation, that could be worse, and gold and oil rise more, as Central banks are forced to cut interest rates to combat the ‘stagnation' part of stagflation. That only worsens the inflation part.

But, even if central banks cut interest rates, we may get a big economic contraction anyway because, so far, Central Bank rate cuts have had virtually zero effect on the spreading credit contraction. If that is the case, we get a severe world economic recession. In such case, gold, commodities and oil likely turn in the other direction. The present price levels will not stay with us.

It is going to be important for gold and commodity bulls to discern if a serious recession is about to emerge which stems both inflation and or stagflation. And such a realization can happen rapidly if there is a big world stock sell off, something we think is quite possible this year.

By Christopher Laird
PrudentSquirrel.com

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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