Will Stagflation Hit Global Economies?

Robert Hsu, March 01, 2008

In case you're not familiar with the term, stagflation is the painful combination of price inflation and a slowing economy. Last October during my visit to Palermo, the capital of Sicily, I witnessed stagflation firsthand. My tour guide, Massimo, complained about stagnant wages and sharply rising prices. There was an air of general tension and discontent throughout the city. I felt the same grim mood to a lesser extent during my visits to Napoli and Rome later that week. I could see that much of Southern Italy was troubled by worker strikes, increased prices of basic goods and an extremely high unemployment rate of 20% or more. Like many parts of Western Europe, Southern Italy is burdened with stagflation, and there seems to be no end in sight.

Currently the European Union is reporting an annual inflation rate of 3.2% in the euro currency zone, well above its target rate of 2%. This increase in inflation happened despite the strength of the euro. (During the past five years, the euro has increased 40% against the U.S. dollar.) But because of the euro's strong value, Europe has actually experienced significantly lower raw material price inflation than the United States. The price of crude oil, for instance, has tripled in U.S. dollars since 2004, but it only went up by 110% in terms of euros. Yet European central bankers, led by ECB president Jean-Claude Trichet, are increasingly worried about rising price inflation.

Perhaps the U.S. should be a bit concerned as well. It's been more than 25 years since stagflation reared its ugly head in America. And with the exception of the Asian financial crisis in 1997 and 1998, most of East Asia has also managed to avoid stagflation since the early 1980s. This year could be the first time in nearly a quarter of a century that the U.S. and many Asian countries need to combat rising stagflation pressure.

As a result of rising raw material prices, higher wages in China, slowing economic growth in the U.S., and stagnant median wages in most developed countries, the risk of global stagflation is higher than at any other time in recent years. A number of leading economic experts are expecting rising inflation combined with an economic slowdown in the U.S. Former Fed Chairman Alan Greenspan declared in mid-December, "The U.S. economy is showing early signs of stagflation as growth threatens to stall while food and energy prices soar." Former Treasury Secretary Lawrence Summers also predicted a rising possibility of recession in 2008.

Although I think it's important to be sensitive to stagflation risks, I'm more optimistic than either Greenspan or Summers. Whether or not the U.S. will be able to avert a recession will depend on continued U.S. consumer spending and export growth.

So far, spending looks good. The latest GDP figure from the fourth quarter shows that U.S. consumers increased spending by 2% from a year ago, and the latest retail sales numbers show an increase of 0.3% in January. Economists were expecting a decline of 0.3% but saw an increase instead. These numbers are still healthy for the economy.

On the exporting front, things are strong thanks to a weak U.S. dollar. In the fourth quarter, U.S. exports grew by 4.4%. China, in particular, has become the fastest-growing major export market for the U.S. Over the past five years, U.S. exports to China have grown at five times the pace of U.S. exports to the rest of the world, and China has become the fourth-largest export market for the U.S. As Chinese domestic consumption continues to grow at a double-digit pace, I expect to see further strong export growth from the U.S. to China.

The latest data show that U.S. consumers continue to spend, signaling that we're not in a recession. Given the magnitude of the recent stock sell-off, many high-growth Chinese stocks are starting to look more attractive to long-term investors again. At this point, I think it makes sense to start buying. And we're going to do that this month with a dynamic Chinese company that's a leader in its industry.

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