The Stagflation vs. Deflation Debate

I've been asked by a lot of people to comment on Mike Shedlock's recent attack on Peter Schiff, and his view that America is facing a deflationary recession rather than stagflation.

There should be little doubt for any regular reader of this blog that I disagree with Shedlock, as I've repeatedly argued for the stagflation scenario. So, why do I disagree with him? Well, to some extent it is a case of our old disagreement about the money supply definition. But I'm going to comment on Shedlock's specific fallacies in the articles.

Shedlock Fallacy #1: "There are constraints on the Fed that he ignores. For example the Fed cannot simultaneously target both money supply and interest rates. Should the Fed pursue a massive printing campaign, interest rates will rise."

No, not true at all. That's the old fallacy that interest rates will necessarily rise in response to higher inflation. But that's only true if the central bank agrees that higher inflation should be met with higher interest rates, which is often not the case, and which is why real interest rates are often negative (like now).

If the Fed decides to buy all government bonds (or corporate bonds or mortgage backed bonds) until the yield fall to whatever level they like, say 0.5% or 1%, there's nothing anyone can do to stop them since the Fed has unlimited power to create money out of thin air. Even if all private investors and foreign governments dump their bonds, the Fed can still simply buy them all with the money they create out of thin air. That implies massive inflation and extremely low interest rates at the same time.

Shedlock Fallacy # 2: "Regardless of what anyone thinks, prices can only rise to the extent that people can afford to pay for goods and services or that banks are willing to extend credit. Without a driver for jobs, and with downward pressure on wages for the jobs we do have, prices will be constrained. If somehow prices rise above people's ability or willingness to pay for them, there will be not be buyers."

No, no, no. If this were really true, we wouldn't have hyperinflation in Zimbabwe where we've seen a severe depression with regard to production and unemployment.

Shedlock is here in essence arguing for a Keynesian "aggregate demand" view of inflation, according to which stagflation is impossible. But as stagflation is a real phenonema (in its most extreme form in Zimbabwe), this argument is simply false.

Shedlock fallacy #3: "That assumption is the US dollar drops....The fundamentals in the UK and EU are as bad as in the US and the property bubbles just as big."

That's actually to some extent true with regard to the U.K.,as I recently explained, and this is why I am bearish about the pound too.

However, the situation is not as bad in the Euro area, which still has a current account surplus.

While Shedlock agrees that the yen will rise, he overlooks the more important yuan, whose continued rise vs. the dollar is a certainty and which will help push up inflation in America, both by making imports from China more expensive and as this increase their demand for commodities given a certain dollar price.

Shedlock fallacy #4: "Take away the US market for goods and China and Japan have massive overcapacity. Without exports to the US and Europe, China would crash. This situation might change 10 or so years down the road, but export economies are not remotely close to being able to ignore the US consumer, at least not now or anytime soon."

Not entirely untrue, but Shedlock overlooks the fact that China has undertaken drastic actions to restrain domestic demand in the form of umpteen increases in interest rates and bank reserve requirements. They thus have a lot of scope to compensate from falling U.S. consumer demand by simply refraining from continuing with these tightening measures or even reversing them.

Shedlock fallacy #5: "Given massive overcapacity in housing, commercial real estate, restaurants, nails salons, etc there is simply no reason for businesses to want to expand business. Nor is there any reason for banks to be willing to extend credit to all but the most credit worthy borrowers. Rising defaults may even impair capacity to the point many banks are unwilling or unable to lend at all. The only reason expansion got as carried away as it did is the psychology at the time suggested residential and commercial property would forever rise.....

....Because the Fed can encourage but not force lending, that shift in the pendulum affects the Fed greatly. The Fed can enhance the current primary trend (as it did in the creation of the housing bubble), but neither the Fed nor anyone else can reverse the primary trend.

Regardless of encouragement, who are banks going to be lending to when asset prices are falling and unemployment is headed higher? And those are conditions that both Schiff and I agree on. With enough defaults, banks will become so capital impaired they could not lend even if they wanted to! We are seeing signs of that in Citigroup already.

And as I have said before, the Fed is a private business. The Fed is not going to give away money any more than Pizza Hut is going to give away free pizzas for a year to all comers." [the last section was from Shedlock's second post]

Here Shedlock makes two fallacies. First, there is no evidence that the banks are refraining from lending, as bank lending has in fact accelerated in recent month during the alleged "credit crunch". In the 20 weeks between August 1 and December 19, commercial bank lending rose 5.85%, which is 16% at an annual rate. Many banks will likely lend on the basis of bailing out their borrowers, knowing that they will fail if they don't.

Secondly, and much more importantly, even if banks get unwilling to lend, they (and the Fed) can then simply start buying securities, and that way expand the money supply, something Murray Rothbard pointed out to the Mike Shedlocks of 1991 in his essay "Lessons of the Recession".

The one thing true Shedlock pointed out was that the stagflation vs. deflation debate mattered because it had investment implications. If we have stagflation, commodities are the place to be, if we have deflationary recession, government bonds are the place to be. To bad for Shedlock then that he and others who invest in government bonds are going to get screwed big time as inflation takes away their value.

Curiously, he argues that gold will do well in deflation (Which we might consider "Shedlock fallacy # 6"). Well, to the extent he invests in that he will be a winner despite his false view of the economy. But, he is simply wrong that gold will do well under deflation. Deflation here refers to the real value of paper dollars, not gold, and if the value of paper dollars were to rise that would imply a falling relative value of gold which unfortunately is not used as money and since 1971 lacks any link to the U.S. dollar.

His argument that gold is not an inflation hedge because it fell between 1980 and 1999 overlooks that the tight monetary policies of Paul Volcker destroyed the demand for gold as an inflation hedge. With real interest rates high, it made more sense to invest in bonds than gold. Also, massive central bank sales and the dollar rally of the late 1990s temporarily depressed gold.

Now, we see gold make a comeback because central bank sales has been limited and many emerging market bank cental bank actually buying, but most importantly because inflation is accelerating and this increases the demand for gold as an inflation hedge.

The Cloud Cuckoo Land Of Donald Kohn

Report after report are now confirming the arrival of what I've been predicting during the latest year, namely a recession in America combined with higher price inflation i.e. stagflation.

Stagflation is of course mainly the result of Fed policy. Fed policy have caused too much of productive resources to be devoted to malinvestments, particularly in the housing sector, which have caused a negative supply shock as more and more productive capacity is no longer demanded. Moreover, the gradual decline in the savings rate in America has also caused productive capacity to decline also creating negative supply effects. And last but not least, as the Fed again tries to revive the economy by more inflation it finds that this have only a limited effect on asset prices -which is to day, while it have probably limited the drop in house and stock prices,it haven't been able to induce them to actually rise, unlike the development in 2001 when they managed to get house prices to rise rapidly- and instead it have mainly had the effect of boosting commodity prices, which is now causing even the distorted government price indexes to accelerate in their rate of increase.

So how do Fed vice chairman Donald Kohn respond to this development? Well, in short by asserting the absurd. He asserts that the Fed, the institution that pushed America into recession and is now causing price inflation to surge will:

"do what is needed to help growth and keep consumer prices stable"

And just how will you do that, vice Chairman Kohn? I know how you created the opposite development that we are now seeing -see above-, but just what do you plan to do to promote sound growth? Do you plan on abolishing your institution, or at the very least stop inflating?

Similarly, he later dismiss the notion of stagflation by saying it won't happen because

"The situation in the 1970s was much more difficult than anything we are facing now.It was more difficult because in large measure there was a buildup of inflation over a long period, since the mid-'60s on,''

In retrospect, everybody who studied this period agrees that if this process had been cut off earlier it would have been a lot less painful than it was. That is a lesson that everybody on the Federal Open Market Committee understands."

As if Greenspan hadn't been building up inflation for a long time...
But what is clear given the current response of aggresive interest rate cuts in a period of stagflation is that the current FOMC certainly haven't learned the lesson to limit the damage at an early stage. Instead, while maybe reducing the severity of the downturn in the coming months it will certainly create an even greater and much more painful downturn later on.

Stagflation In U.K., U.S.

During the lastest month, consumer price inflation and producer price inflation both rose significantly in the U.K. During previous months, the U.K. actually had surprisingly low inflation compared to the rest of Europe. Until March, the U.K. at 2.5% actually had the lowest inflation rate of all EU countries except Holland(1.9%). But now the effects of the weaker pound are starting to get felt. And as the effects of currency depreciation generally lag quite significantly, it will likely cause inflation to rise even further from the April number of 3.0%, which is going to force Bank of England chief Mervyn King to write a letter to the Chancellor of the Exchequer Alistair Darling to explain the failure to meet the goal and specify what will be done to push it back below 3%. Most likely that letter will likely be a bunch of nonsense ignoring how it is Bank of England policy that is responsible for it, while predicting that inflation will soon fall again without any real basis for that assertion.

Note that this increase in inflation ocurred even as the U.K. economic growth is rapidly deteriorating, indicating that the U.K. economy is increasingly characterized by stagflation.

Another economy charactericed by stagflation is clearly the U.S., something which was confirmed by today's reports. The import price index rose another 1.8%, and is up by a full 15.4% the latest year. Even the index for non-fuel imports rose 1.0% compared to the previous month and with 5.8% compared to 12 months earlier. Tomorrow's CPI report should show a lot slower increases as the BLS assume large seasonal increases this time of the year. Still, the increase should be comfortably above zero.

Meanwhile even nominal retail sales fell last month and rose just 2.0% compared to 12 months earlier. This implies that real retail sales are falling significantly.

Stagflation Ahead

One interesting aspect of the economic turmoil is that as a matter of fact, monetary conditions aren't really tight. As I recently reported, euro area monetary growth in July reached an all-time high during the existence of the euro, yet the ECB cancelled the previously signaled rate hike. Meanwhile, the most recent numbers on bank lending and money supply growth in America surprisingly indicate that not only did they decline in August, they accelerated somewhat. M2 and commercial bank lending have increased 1.5% (annual rate of 20%), and MZM by 3% (annual rate of 40%) during the latest four weeks.Despite this, the Fed is likely to cut interest rates by 25 or perhaps even 50 basis points on September 18th.

It remains doubtful given the loss of confidence whether this can actually prevent -or more accurately postpone- the coming U.S. recession. But one thing is for certain, there is not going to be a deflationary recession like some believe. It will be a case of stagflation. This in turn is going to limit the Fed's rate cuts.

Already responding to this inflationary environment is gold, which reached new highs on friday. Gold -and gold producer's stocks- is a particularly attractive investment during stagflation. Like other commodities it is a inflation hedge. But unlike most others, particularly industrial metals, it is also relatively insensitive to cyclical
downturns.

ISM Indexes Confirm Stagflation Scenario

While the suprising release of the 15 British hostages kidnapped by Iran will push down oil prices somewhat and so increase growth somewhat and lower inflation slightly, other news seem to confirm the stagflation scenario. Of particular interest are the ISM indexes over economic activity. The ISM manufacturing index released monday showed a drop in the overall index from 52.3 to 50.9 and the key new orders component dropping to 51.6 from 54.9. However, the prices paid component showed a rise from 59.0 to 65.5. Similarly, the non-manufacturing index showed a decline in the overall index to 52.4 from 54.3, with the key new orders index falling from 54.8 to 52.8. However, the prices paid component rose from 53.8 to 63.3.

Factory orders data also indicated weakness. Job growth according to the private ADP survey was a bit firmer, but it is well known that employment is a lagging indicator. Meanwhile, a leading lender of subprime mortgages have gone into bankruptcy.

More Evidence of Stagflation in America

The ISM manufacturing index fell to 47.7 in December-the lowest level since April 2003. The details are even more bearish. The new orders subcomponent fell to just 45.7-the lowest since 2001 recession. The production subcomponent also fell sharply and is now well below 50. The only indicator that rose and is at a high level was "prices paid"-an inflation indicator. This again confirms my long held view that America's economy is falling into stagflation.

Meanwhile, oil prices just keeps rising which will further depress growth and increase inflation, i.e. make the economy more stagflationary.

Gold Better Safe Haven Than Other Currencies

After Ben Bernanke in effect decided to lease just about every helicopter in America to flood the country with money -with a disproportione number of helicopters concentrated around Wall Street, of course-, an increasing number of people have finally started to realize that the U.S. dollar and interest bearing assets demoninated in the U.S. dollars sucks bad as investments. So they've decided to take their money into other currencies and interest bearing assets denominated in thoe currencies.

There is however a problem with that. Because public debate and central bankers in other countries are mercantilist in their nature, they will not react gladly to their currencies making new highs against the dollar. See for example here the complaints from exporters in the Euro area. And of course, Asian central banks are infamous for intervening to hold down their currencies.

The sharp increase in the euro makes more ECB rate hikes increasingly unlikely, as they know that further rate hikes would create further upward pressure on the euro. This means that inflation will get worse in the Euro area too. Similarly, the upward pressure on Asian currencies will likely increase their level of foreign exchange reserve accumulation which in turn will expand their balance sheets and so increase their money supply.

Thus, the more inflationary Fed policies will pressure other central banks pursue more inflationary policies to limit the increase in the exchange rate of their currencies. For that reason, it is unwise to rely on other central banks currencies as havens from Helicopter Bernanke's inflationary policies.

The only real haven is in real assets, including commodities such as gold. Stocks are in principle havens from inflation as the nominal value of their profits and fixed assets increase with inflation. However, if you believe as I do in stagflation, then most stocks will still suffer because of the cyclical downturn. The same thing goes with many industrial metals. Gold and some other noncyclical commodities are havens from both elements of stagflation-both inflation and recession. Stocks of producers of these commodities are also likely winners.

Did Anyone Say Stagflation?

While the ISM indexes aren't always reliable, they usually are. The ISM non-manufacturing index fell in September, with the key new orders sub-component falling particularly much. However, the prices paid index rose significantly, all pointing to stagflation.

Further Evidence of Stagflation

I've been telling you for quite some time now that the U.S. faces a significant slowdown, probably a recession, combined with strong inflationary pressures, i.e. stagflation.

Today offered further evidence of that view, with weak manufacturing survey data from New York and Philadelpia. Note however how the price indicators in these surveys rose. And while initial jobless claims fell somewhat, continuing claims rose much more.

Meanwhile producer prices rose far more than Wall Street forecasts, with not only energy and food prices soaring, but even the "core" index rising significantly too.

A Merril Lynch analysis meanwhile argued that unless the Fed cut interest rates, the probability of a U.S. recession is 100%. While I think that a recession now seems more likely than not (i.e. my current estimate is a 70-75% probability), I wouldn't put the probability fully as high as 100% as there is always a possibility of some positive supply shock like another dramatic oil price decline. However, I don't think the Fed will have any room to cut interest rates with inflationary pressures being so strong.

New Numbers Confirm Inflationary Recession (Stagflation)

Recently, just about every number have all confirmed the stagflation scenario I have predicted. This includes jobless claims, the producer price index, durable goods orders, new and existing home sales. Not to mention of course the market movements with a rapid decline in the dollar combined with soaring commodity prices

Yesterday's GDP report indicated that the headline volume growth number stayed unchanged at +0.6%, and the terms of trade adjusted real growth number also stayed unchanged at -0.6%. Domestic demand was revised down but so was the trade deficit, leaving production unrevised.

However,other revisions were clearly bearish. Inflation was revised up with both the GDP deflator and the domestic demand deflator being revised up with 0.1% point each while the Personal Consumption Expenditure deflator was upwardly revised by 0.2%:points. Meanwhile, disposable income was revised down even in nominal terms and much more so in real terms.

Today we got the monthly breakdown on that downward revision, with most of it coming in November and December. Real disposable income rose slightly in January, but this was entirely a result of temporary factors such as expired options and other bonuses. Despite these factors, real disposable income remains 0.2% below the September peak, confirming the beginning of a recession during the fourth quarter of 2007. This is likely to become even clearer after these numbers have gone through the annual revision in late July. These revisions always result in a downward revision of real growth and an upward revision of inflation. For example, the real growth rate for 2004 was initially reported as 4.4% while the GDP deflator was reported to rise 2.1%. After the 2007 annual revision it was said that growth was only 3.6% while the GDP deflator is said to have risen 2.9%.

With consumer price inflation soaring and nominal income growth likely remaining slow, this implies that real income will likely fall faster in coming month (also in February, the removal of the temporary factors that boosted the January number will also contribute to a deeper monthly decline. And with the savings rate being negative and asset prices falling, this will also imply a decline in personal consumption which in turn will contibute to faster declines in terms of trade adjusted real GDP.

Stagflation Is Not "Mixed Signals"

AFP reporter Rob Lever reports about the dilemma for the Fed as inflation remains high, while the subprime mortgage meltdown creates a risk of a recession. So far, so good, that's what I've been telling you for some time.

The problem is that he labels this as being "mixed signals", thus revealing his Keynesian bias. But the combination of falling output and rising inflation is not a case of "mixed signals". It is a case of stagflation.

Stagflation With a Vengeance

BBC Business News reports that Zimbabwe's consumer price inflation rate rose above 500%. But don't worry. I'm sure some Mugabe apologist can say that if you exclude food, fuel, home rentals, bicycles and maybe some more rapidly rising items, then we come up with some "core" rate of inflation which aren't really that bad.

Given the fact that Zimbabwe have at least 60% unemployment (Some argue its more like 70-75%) and a rapidly falling GDP it would be interesting to hear how all the pundits who argue that the ECB pursues a "tight" monetary policy would charactarise Zimbabwe's monetary policy. After all, despite the fact that the Euro-zone have rapid money supply and credit growth, rapidly rising house prices and a consumer price inflation rate firmly above the ECB:s supposed ceiling, 2%, they still regard it as tight , using as evidence the high unemployment rate and sluggish growth. This they argue is evidence of "slack" in the European economy. But in Zimbabwe where GDP is collapsing rather than growing slowly, and unemployment is 60-75% rather than 8.3%, there is arguably a abundance of "slack". Given this, should Zimbabwe's monetary policy be regarded as "tight"? If money supply and price growth is irrelevant in the Euro zone, shouldn't this hold true for Zimbabwe too?

In Zimbabwe's economic collapse is of course the result of the disastrous policies of black racist dictator Robert Mugabe, most notably his policy of stealing the lands of productive white farmers and giving it to his in agriculture obviously incompetent cronies. Zimbabwe's combination of 500% inflation and 60-75% unemployment is what one might call stagflation with a vengeance. EU policies are of course far less destructive, but it is still they who are responsible for the high unemployment and sluggish growth, and any attempt to substitute market reforms with inflation will only worsen EU problems .

VAT Increase Is A "Supply Problem"

Scott Sumner notes that Britain both have low nominal growth and high inflation, or as he puts it have both a demand and a supply problem, but argues that the inflation numbers are "biased" because of a VAT increase.

Actually though, VAT increases, just like other tax increases, do create "supply problems" since they will cause the supply of goods and services at the old prices to decrease, raising prices and lowering real output. Tax increases, including VAT increases, are in other words a recipe for stagflation. Britain may have other "supply problems", but the increases in the VAT and various other taxes in recent years are certainly among the most important.

Will Europe Decouple?

Now that it is increasingly indisputable that America has in fact slipped into a recession, the debate has shifted to whether or not the rest of the world will decouple from that downturn. In the case of Europe I have for a while argued that it will. I still stand by that view, but I should clarify it.

There is simply no rational reason for believing that an American downturn will cause a European downturn. Exports to the U.S. are in fact only about 2% of Euro area GDP. And even that overstates the dependence as it compares apples to pears. Exports are expressed in gross terms while GDP is expressed in value added terms. This is to say, some of the inputs used to produce that exports is imported. I don't have an exact number for how big distortion this creates, but it is nevertheless clear that an apples to apples comparison would show an even smaller dependence.

So, even a dramatic decline in exports to the U.S., say in the magnitude of 25-30% would only reduce Euro area GDP by a few tenths of a percentage point.

A somewhat stronger argument for believing in recoupling rather than comes from financial markets. As is obvious to anyone who follows the U.S. and European stock markets, there is a strong link between them. Whenever one falls, the other usually follows. This link is to a large extent based on the fallacy of a strong connection in the real economy based on trade that I refuted above, but it might to some extent be a self-fulfilling prophecy. But while it is a real factor, it is implausible to be significant enough that irrational stock market sell-offs is sufficient to push the European economy into a recession, especially as most continental European counties have much lower stock market capitalization to GDP ratios than for example the U.K. or the U.S.

However, while the U.S. downturn will not by itself cause a European downturn, that does not necessarily imply that a European downturn will not happen. It probably will not happen, but it might. If it does, however, it will be the result of home grown factors.

More specifically, some parts of Europe have experienced similar stories of excessive credit growth as the United States, and this will likely cause busts in these countries. We have already seen how Ireland has slipped into a recession, and the Baltic states are showing worrying signs of stagflation with double digit inflation and a sharp deceleration in growth. Both Ireland and the Baltic states are by themselves far too small to cause a European wide downturn. More worrisome is that Spain and Britain show signs of potentially slipping into a recession. Spain and Britain have both experienced similar kinds of housing bubbles as America and Ireland, and while there is no evidence yet that either country has slipped into a recession, there is a real possibility that it might happen. And if it did, it would be very serious for the overall European economy. While the German economy looks quite sound and strong as a result of years of free market reforms and austerity, it could have problems adjusting to a possible significant downturn in Spain and Britain.

At this point, there exists a great amount iof uncertainty over how the Spanish and British economies will develop, as well as how the overall European economy will develop. They may or may not slip into a recession. If they do, this will certainly hurt the German economy significantly. However, the point here is that while Europe may perhaps experience a downturn, this will not be a result of the American downturn. Instead it will if it happens be a result of the negative after effects of local bubbles.

How Should The Money Supply Be Defined?

Mike Shedlock argues against the view that there is strong inflationary pressures in the U.S. economy. Since I am one of those who have argued for that view, I feel I must reply. Ultimately, the disagreement is a disagreement of how the money supply should be defined. The broader definitions that I favor show a lot faster growth than the narrower definition that he favor.

Mike Shedlock is generally a good economic analyst, but he suffers from one fatal flaw: he believes in Frank Shostak's definition of the money supply. The problem with that is that Shostak have a far too narrow definition. Exactly which items are included in that definition is not clear, as he in his article about the money supply only argues against including certain items, rather than specifying exactly what is included. But it seems fairly similar to M1.

Shostak for example excludes Money Market Mutual Funds despite the fact that you can use your holdings in them as a means of payment by for example writing a check on the ground that when you write a check you instruct the fund to sell assets and then the money is transferred to the holder of the check and so money is only transferred, not created. But this is just another case of Shostak being completely clueless. Advocates of including MMMF:s in the money supply have never argued that money is created when people reduce their MMMF holdings by for example writing a check. Quite to the contrary, here the money supply is being reduced as MMMF holdings fall while the amount of cash is held constant and transferred from the buyer to the seller. The money creation instead occurs when people deposit money in MMMF as the seller of the assets receives cash while the depositor simultaneously also has money in the form of MMMF assets, while before the transaction only the future depositor had money in the form of cash.

Shostak also argues against including saving deposits because banks formally have the right to insist on a 30 day waiting period. But to this Murray Rothbard pointed out:

"The objection fails to focus on the subjective estimates of the situation on part of the depositors. In reality, the power to enforce a thirty day notice on saving depositors is never enforced; hence, the depositor invariably thinks of the savings account as redeemable in cash on demand. Indeed, when in the 1929 depression, banks tried to enforce this forgotten provision in their savings deposits, bank runs promptly ensued"

Thus, since money deposited in savings deposits can be used as a means of payments they should be included in the money supply. That should be the general principle in determining what is and what isn't money: can it be used as a means of payment. That would indeed include both savings deposits and MMMF:s.

Shedlock also tries to put up an empirical defense of Shostak’s definition. He claims that it accurately predicted 6 out the latest 6 recessions, although he concedes it gave two false signals, in 1985 and 1995. However, looking at his chart, it did not in fact predict the most severe of all recessions, the one in 1981-82, where it fluctuated between 5 and slightly above 10% during and before the recession, but did not show a downward trend.

What's worse, the measure failed to predict the late 1990s tech stock bubble, as money supply growth remained moderate during the entire era. By contrast, measures like M3 and MZM did rise in reflection of the tech stock bubble.

Also, recessions need not be associated with falling money supply growth if there is stagflation. Money supply growth has been extremely high and rising in Zimbabwe recently, yet Zimbabwe has suffered a sharp drop in economic activity. It all depends on who the early receivers of money are and how they use it. Sometimes it can cause tech stock bubbles, sometimes it can cause housing bubbles and sometimes it can simply cause consumer price inflation. Theoretically it can also have no effect at all on any prices if the early receivers decide not to use it. The latest acceleration in monetary growth is most likely to cause an acceleration in consumer price inflation, which I expect to rise above 4% later this year.

U.K. Economy Took Stagflationary Turn The Last Quarter

Today's U.K. GDP number was much weaker than expected, showing a 0.5% (2% at an annualized rate) quarterly contraction, while most economists had expected a 0.5% expansion. I for one thought that was over-optimistic,particularly given the weather, and expected a growth number around zero, but the real number proved to be even weaker than that.

This contraction is blamed on the weather factor, with December being the coldest in 100 years. And I certainly agree that the weather depressed the U.K. economy, and the reversal of this will boost future growth numbers. However, with growth being zero even excluding the weather effect, underlying growth seems to be very weak too.

And even with growth weakening, consumer price inflation rose to a new high of 3.7% in December, creating a picture of stagflation inthe U.K.

The VAT increase that was just implemented will enhance this stagflationary trend, as it both reduces real output while boosting price inflation.

The VAT increase along with a weak underlying economy create a risk of a double dip recession in the U.K. However, the probability of that is probably less than 50% given the reversal in the weather factor and the fact that most economies of the rest of Europe as well as most of the rest of the world, seem to be picking up speed, something which will help counter the contractionary factors.

Demand Driven Stagflation?

It is pointed out by Brad DeLong that the British economy has fared worse than even during the 1930s, since 2008.

The numbers are even worse if you adjust for the fact that the British population has increased by more than 2% during the period, though population increased almost as much in the 1930s as well.

DeLong of course blames Cameron's austerity policies, but there is a problem (actually there are several). That would suggest that the slump is demand driven, and if that had been the case we would have seen price inflation fall. But as it happens, inflation has increased the last few years and is at an annual average of 3.6% the last 3 years the highest since the early 1990s, and also significantly above the alleged 2% target of the Bank of England.

British inflation has also been a lot higher than in almost all other advanced economies. For example Sweden, whose economy has fully recovered even on a per capita basis, had an average inflation rate of 1.75% during the last 3 years.

The part of the austerity package that involved higher taxes (mainly a higher VAT) is really the only part that can explain this since they represent a negative supply shock that both raise price inflation and reduce real output, but that should have largely been cancelled out in part by the reduction in real disposable income from the tax increases and in part by the spending cuts.

Latest News About the U.S. Economy

A lot of important news about the U.S. economy has been released during the latest 24 hours. Including last night's flow of funds report, the trade balance report and the employment report.

Starting with the flow of funds report. It was actually somewhat more bullish than I had anticipated. While household debt again rose to a new all time high, to 131,8% of disposable income up from 130,4% the previous quarter, it was still a lot slower increase than expected given the much sharper increase in bank lending. Presumably, this apparent statistical discrepancy is a result of a significant slowdown in non-bank lending.

Another bearish number was a continuing decline in owner's equity in homes, which fell to a new all-time low of 53,1%. Yet another bearish indicator was the corporate financing gap (the amount of money corporations need to raise from outside sources) which rose to an annual rate of $70,5 billion, up from $48,3 billion in the third quarter. For all of 2006, the gap was $47,1 billion, compared to a surplus of $138,3 billion in 2005.

One bullish number was the significant increase in household net worth, which occurred despite higher levels of debt and the slower house price increases. Indeed, asset values and therefore net worth increased faster than debt for the first time for quite some time, lowering the debt to net worth ratio. This was the result of the stock market rally last year, which is illustrated by the fact that mutual fund shares and pension fund reserves were the assets that increased the most. This bullish trend is however unlikely to continue in the first quarter of 2007 as stock prices have been stagnant.

Turning now to the trade deficit number, it came in roughly as expected at $59,1 billion. Contrary to Gregg Robb of marketwatch, however, it won't add to first quarter GDP, as the deficit was somewhat higher than in October 2006, both in absolute number and in the "2000 Chain-Weighted Dollars" used for calculating real GDP growth.

The employment report was seemingly bullish at first glance. For some reason, "professional analysts" are obsessed with the non-farm payroll number, even though it is actually one of the less relevant. And as the non-farm payroll number came in line with expectations and as the unemployment rate fell and average hourly earnings increased a full 0,4%, the number was interpreted as a vindication of the bulls.

However, the small increase in non-farm payrolls masks a unusually large decline in the more interesting number of hours worked, which fell 0,3%. And the decline in the unemployment rate was a result of a significant decline in the labor force participation rate. Employment actually fell according to the household survey and is lower than two months ago.

The increase in average hourly earnings will likely be cancelled out by an even bigger increase in consumer prices as energy prices have recovered from the January lows and both food prices and "core" prices rise rapidly.

So, contrary to the Wall Street interpretation, the employment report was bearish as hours worked and probably also real wages fell, supporting the stagflation scenario I've predicted for some time. Also supporting this is the fact that commodity prices have started to rise again after a brief correction, while rising level of defaults of sub-prime mortgages is likely to put further pressure on the housing market.

Stagflation Coming

This news item certainly supports the "hawkish bear" point of view that I have been arguing for. While commodity prices have pulled back somewhat from recent highs as traders have betted that a U.S. recession will lower prices, they will likely rise again because of a falling dollar and strong non-U.S. demand.

Icelandic Stagflation

In a bid to stabilize its currency, which is down 70% this year, Iceland raised its interest rate from 12% to 18%, after having cut it from 15.5% just a few weeks earlier. To the extent it succeeds, it might actually strengthen the economy, as the excessive weakness of the krona is the key problem facing the Icelandic economy. Not only does it contribute to a sharp increase in inflation, but by increasing the domestic currency value of its foreign debt, it makes the problem of too much debt even worse. However, in these times of extreme risk aversion from investors, it can be questioned just how effective it will be. Moreover, given the extremely high level of inflation in Iceland, 18% isn't exactly high.

To get a perspective on how bad things are in Iceland, the forecasts in this Bloomberg report are useful.

"The central bank is raising rates as Iceland, the first western nation to seek financial help from the IMF since the U.K. in 1976, faces an economic contraction, coupled with possible hyperinflation and rising joblessness. The economy will shrink as much as 10 percent next year, the IMF forecasts. Iceland will receive about $2.1 billion from the Washington-based fund, according to a deal struck on Oct. 24....

....The increase in the key rate comes after the central bank on Oct. 15 cut it by 3.5 percentage points from 15.5 percent. That move indicated policy makers were focusing on growth and abandoning their target of stabilizing inflation, which may soar as high as 75 percent in coming months, according to Lars Christensen, chief analyst at Danske Bank A/S in Copenhagen."

And I personally think that a 10% contraction is probably on the optimistic side.