The Myth and Truth of Stagflation

Record High inflation and a Recession in Sight? The Mechanics of Stagflation

With Oil price hitting $100 again, the threat of stagflation becomes very very real. Many blame the rapid inflation due to the rising demand of China and India. The truth is, the real rise of demand does not match the rise in the prices of these commodities. Let's look at some hard facts and truths

The Definition of Stagflation

Stagflation refers to a period of high inflation and negative economic growth. This is probably one of the worst scenario for a recession. Jobs are lost and wages are coming down. Normally, when consumption falls in a recession, prices fall. In this case, prices of daily necessities continue to rise, creating a pinch for households. The primary finger pointing towards the reason for stagflation is non other than the rapidly rise of commodities prices.

The Demand for Oil

Oil: The lifeblood of any economy. The number one essential commodities in the world. World War II was waged, partly due to empires trying to control oil rich nations to fuel their expansion. Today, many blame China and India for their rapid development and the thirst for more energy to fuel their economic boom. Let's look at some statistic on the barrel of oil comsumed daily from the top 10 oil consumption nations. The demand from these top 10 countries constitutes for more than 50% of oil consumption in the world.

What is interesting to note is that, demand for oil from China actually fell in 2007 compared to 2004 and the total demand of oil from the top 10 has actually fallen since 2004. In fact, the demand is similar to that in year 2003. What is the oil price in 2003? It is only $30 . In short, the relationship between demand and pricing is breaking down. Reason for such rapid irrational rise? One good reason is probably due to speculation activities from institutions and hedge funds. The other interesting fact to note is that US actually accounts for nearly 25% of the world's consumption. The rise of oil prices should be attributed to the increasing demand from US rather than China and India. With the US going into or is already in a recession, the demand for energy should fall. The health of the US economy probably has probably a bigger dampening effect than any other country in the world. So, why didn't the market take into account of this too?

Another interesting fact to take note is the OPEC feels that the supply for oil is more than sufficient and do not see the need to increase supply. In fact, some of the member countries are requesting the cartel to reduce supply. Still, oil prices continue their relentless pace upwards.

The commodities market is going into a period of potentially irrational exuberance. With real demand being dampened in US, the prices of commodities is going to come down one day and the threat of stagflation will diminished.

The Threat Diminished

The Equity market has been moving laterally since the rapid interest rates cuts by the US central bank in January. The US Congress has passed a package to rescue distressed mortgage owners. More help is seen coming from the government. With aggressive fiscal and monetary actions in place, the market is expected to recover rapidly in the second half of the year. The stock market is getting back on its feet and is expected to move laterally for a couple of months longer. Hopefully, the real demand for commodities can be realized and prices will come down. This will swerve the economy from a potential stagflation scenario, allowing global central banks to cut rates without the fear of combating inflation. Stay cool in the face of volatility and the rewards will be there at the end of the rainbow.