Stagflation shakes economists' outlook

Stagflation in some of the world's major economies is shaking the outlook for at least two prominent Canadian economists.

Sherry Cooper, chief economist at BMO Nesbitt Burns, is wondering aloud whether the way central banks in developed and emerging markets manage stagflation will provoke a global currency crisis.

And Jeff Rubin, chief economist at CIBC World Markets, is slashing his expectations for the Toronto Stock Exchange because of the way stagflation will affect companies exposed to energy and transportation.

“We are lowering our TSX targets for both this year and next, in light of the latest changes to our economic forecast that paint an increasingly stagflationary macroeconomic environment, particularly south of the border,” Mr. Rubin wrote in a note to clients Monday.

While he remains bullish on oil and natural gas prices, he recommends reducing equity holdings in favour of cash.

Holding cash may be a problem, however, if Ms. Cooper's musings pan out. In a downbeat piece titled, “Next Shock: Currency Crisis?,” she discusses what could happen to exchange-rate stability as the U.S. Federal Reserve struggles to deal with rising inflation and slowing growth at the same time.

With inflation on the rise, the Fed can't cut rates any more, even as its economy deals with a recession. Other Group of Seven rich countries are teetering as well, and in Canada “Ontario's economic decline portends the spreading pain,” Ms. Cooper wrote in a note to clients published on Monday.

But G7 interest rates are already too low for the likes of emerging market economies with their currencies pegged to the U.S. dollar, she said. These countries' strong demand is pushing up the price of global commodities, but their central banks don't have the flexibility to raise interest rates because their currencies are pegged. So, indirectly, they are importing too-low interest rates from the United States.

“If the Fed refrains from raising rates because of economic weakness, despite the rise in inflation, pegs will come under significant further pressure,” Ms. Cooper wrote. “This is a pressure cooker running over the boiling point.”

At some point, the global economy could discover that the U.S. dollar is not the right peg.

“If several dollar-pegged currencies were revalued, we could expect to see some panic selling in the U.S. dollar, further destabilizing the global economy,” Ms. Cooper said.

The term stagflation became common in the late 1970s and early 1980s, as many countries strained to deal with simultaneous stagnation of growth and rising inflation prompted by soaring fuel prices. It's thought that stagflation is one of the trickiest economic problems for policy makers to deal with, since efforts to reignite growth often exacerbate inflation, and efforts to stifle inflation often also stifle growth.

The conventional wisdom now among central bankers is that it is more important to fight inflation - by not cutting interest rates, or perhaps raising them - even if it hurts growth prospects in the short term. That's because a short-term sag in growth can be fairly easily fixed, but rising inflation tends to be more intractable.

In the United States, the economy is likely in a recession, with growth at a standstill and employers eliminating jobs. But inflation is running at a 4 per cent annual pace, prompting the Fed to put an end to its rate-cutting streak.

Similarly, in Canada, growth has stagnated, but there are some signs that total inflation is creeping up. So the Bank of Canada abruptly halted its rate cuts last month, and is expected to remain on hold next week.