Stagflation Dilemma

By Callum Roxburgh

Central Bankers in the developed economies are faced with a dilemma, while economic growth is slowing and their economies are slipping into a recession, energy and food driven inflation is preventing them from cutting rates. The worry is that this inflation will lead to wage increases that will then drive a self sustaining inflationary cycle. While they may be handcuffed by inflation in terms of using Monetary Policy to stimulate growth, the prudent use of Fiscal Policy could increase consumer spending and at the same time reduce demands by workers for outsized wage increases.

The current inflation is being driven by demand in the developing world; the voracious Chinese economy in particular has increased competition for the world’s finite supply of basic materials. As the average Chinese worker has seen his spending power grow he has increased his consumption of meat. Since it takes 10 kilos of grains to produce 1 kilo of meat we have seen an increase in grain prices. As his wages have increased further he has traded in his bicycle for a Motor Scooter or Automobile, thereby increasing demand for hydrocarbons. This demand growth has been outstripping the rate at which supply has been able to catch up. Since this is a demand driven inflationary cycle, as opposed to the supply driven cycle we saw in the 70’s, it is unlikely that we will see a significant decrease in prices in the short term.

Increasing the spending power of consumers in developed economies will not have a significant impact on basic materials inflation. Faced with increased costs every time they fuel their vehicle, they are not going to stop driving and walk to work. They are going to compensate by reducing spending in other areas. They may chose to spend less money on holiday travel or eat less in restaurants or forgo their White Chocolate Mocha Frappuccino, evidenced by Starbucks reporting its first quarterly loss in Corporate History.(1) These activities are not resource intensive so reducing them will have little impact on resource demand.

The impact of the US stimulus checks allowed the US economy to achieve 1.9% annualized growth in the second quarter compared to 0.9% in the previous quarter. (2) I was quite critical of this approach when it was announced and I still am. While the supporters of this kind of stimulus will use the increased growth in the second quarter as evidence of its effectiveness, what happens next quarter? Will we see economic growth fall?

A much better approach would be to deliver a permanent tax cut that was targeted at all taxpayers. This could be done by lowering the percentage of the lowest tax band or increasing the basic exemption that allows income to go untaxed. This would be stimulating to the economy and at the same time would head off outsized wage demands by workers who would feel less pressured by rising food and energy prices.