The latest frenzy over the multiple, repeated sightings of the dreaded stagflation enemy is perfect fodder for the media. Fear is the primary staple of financial journalism. Expect to see a lot more debate on stagflation in the coming days. Our take on this is fairly simple: the booming period of growth, in any meaningful sense of the term, is over. Whether we are technically in a recession or merely on the cusp of one is immaterial; there is growth only in isolated sectors and pockets of the economy. Further, there are compelling reasons to believe that a contraction this time around would be more severe and more protracted than the previous two recessions. The significant slump in demand should prove to be a sufficient douse to the inflationary fire. The peeling of the sub-prime onion has led to a collapse in residential real estate prices, on a scale not witnessed since the 1930s, a remarkable unraveling of the dangerously over-leveraged and reckless - yet all-important - banking system and a dramatic increase in household insolvency. This has created an economic Lernaean hydra, not seen since the Great Depression.
Having said that, it is important to appreciate the risks as they are. A persistently weak dollar (the dollar has lost 37% of its value in the past five years) raises the price of all dollar-denominated commodities, such as oil and other raw materials, as well as imported goods. Even if consumption of products falls in the United States, resilient demand from emerging markets such as China and India could cause prices of many goods to remain persistently high. Counter-intuitively, the only malaise for a stagflationary scenario is a significant recession in the US that also takes down global growth with it.
The Fed is in a Catch-22 situation, caught between a possible stagflationary environment versus the serious risk of a general deflationary collapse and onset of a protracted, depression-like economy. The Fed now knows which is the greater of the two evils. A 125 bps rate cut in January signaled beyond doubt where the Fed's concerns lie. The sharp plunge in economic indicators over the last few weeks is consistent with an economy that is rapidly spiraling towards a recession. An expected slowdown which requires monetary easing of that magnitude will surely pull demand down with it.
We believe the Fed will cut rates at least another 25 bps at its March 18 meeting (and quite possibly 50 if we get another dreadful unemployment report) We would not be surprised to see the target Fed funds rate at 2% by the middle of the year. But, having said that, there will certainly be more reluctance to follow the easing path here on.
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