Temporary stagflation still stressful

Written by Stephen Poloz

People are getting worried about inflation, and no wonder. Energy costs have skyrocketed, and since energy is an input into almost everything else, inflation could easily head a lot higher.

So far, at least, it is not happening. Overall inflation has accelerated to 4.7% in the U.S., and to 3.4% in Canada. Energy prices are up 21.4% over last year in Canada and a stunning 34.8% in the U.S. But that is just arithmetic — when a price rises, so does inflation, but unless that price keeps rising, and then affects other prices as well, there is no emergence of inflationary behavior.

Core inflation, as it is commonly called, excludes food and energy, which are often volatile, and core inflation is running at only 2.0% in the U.S. and 1.6% in Canada. No immediate cause for concern there, except that central banks worry that higher energy costs will next get passed through the system, boost inflation across the board, and then get embedded in wage costs, and so on — in other words, behavioral inflation, not simply arithmetic inflation.

Central banks are raising interest rates now to reduce the risk of an acceleration in behavioural inflation. Higher interest rates will moderate demand in the economy overall. Non-energy sectors will feel this the most, of course, because the energy sector is booming. The effect on non-energy sectors will be twofold: higher energy costs will drain purchasing power from other sectors, and higher interest rates will drain purchasing power from all sectors.

The result will be a little bit of stagflation, although not the ugly kind we saw back in the 1970s. A combination of slowing growth and rising inflation is a natural consequence of an energy price shock that collides with a cautiously restrictive monetary policy. The situation is nothing like as severe as it was in the 1970s, because inflation is so low today and the economy much healthier.

But there is another downside to the story. Because inflation is so low, the moderation in growth coupled with the transfer of purchasing power from non-energy to energy sectors can easily lead to deflation in some parts of the economy. With companies dealing with higher energy and raw material costs already, the prospect of declining prices for their products must appear daunting.

In Canada, the rate of inflation of goods (excluding food and energy) is now just 0.5%, so it will take only a modest further deceleration to move into deflationary territory. Prices of household furnishings are already falling, along with prices of recreational services. Clothing inflation is only 0.5%. The U.S. situation is not much different, as apparel prices are falling at a rate of 0.6%, household furnishings are rising at only 0.6%, and recreational services are running at 1.0%.

The bottom line? Central banks can take some satisfaction that economies can handle energy price shocks today much better than in the past. But the stagflationary pressures of yesteryear will still show up in some sectors, compounding the stresses of a slower growth outlook.

October 27, 2005

The views expressed here are those of the author, and not necessarily of Export Development Canada.

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