The latest U.S. inflation numbers and the expectation of another interest rate cut by the Federal Reserve Board make "stagflation" - not recession - the real challenge facing the U.S. economy.
The focus on recession by many economists and by the media has distracted us from the serious medium-term risk of U.S. stagflation, which combines strong inflationary pressures with stagnant economic growth - as happened during the late 1970s and early 1980s. True, the U.S. housing sector is a disaster and job creation has been anemic, but U.S. growth was still positive in the fourth quarter of 2007. The U.S. consumer has not disappeared - monthly retail sales numbers for January suggest weak but positive U.S. consumption growth, despite a collapse in auto sales.
Conference Board forecast
The Conference Board of Canada's forecast for the United States readily acknowledges the significant risks to the U.S. economy, but we have stopped short of using the R-word.
Even if the U.S. dodges a recession, U.S. consumption growth could crawl along at a low level for years to come. Americans will continue to be hobbled by falling house prices, weakened equity markets, high energy prices and a heavy personal debt load, all of which could hold back a rebound in spending growth.
U.S. core inflation, at 2.5 per cent in January, does not appear to be out of control at first glance, but a depreciating currency and high and rising commodity prices are adding fuel to the fire. Tight global market conditions for agri-food products, driven in part by expanding ethanol production and fears of a wheat shortage, are adding food price momentum. Additional food supply capacity is not readily available, unlike consumer goods and business inputs, where the "China effect" has kept price increases under firm control. Not surprisingly, total U.S. inflation has climbed to 4.4 per cent, and it has soared to an annualized rate of 6.8 per cent over the past three months.
Inflation
The critical ingredient for either restoking or calming the fires of inflation is U.S. monetary policy. Inflation cannot accelerate seriously without rapid liquidity expansion by the central bank. On that front, the Fed chose to intervene aggressively in December and January to head off recession, and what it saw as an incipient meltdown in equity and financial markets. Short-term interest rates were slashed by 225 basis points in just a few weeks, with promises of more interest-rate cuts to come.
We understand the short-term pressures faced by the Fed - such as the risk of a large number of subprime mortgages being reset this spring at much higher interest rates. That said, the core job of every central bank is to keep inflation and inflationary expectations in check, as some have argued recently from within the Fed itself. The Fed will need to act aggressively later this year and into 2009 to unwind the recent rate cuts, if it is to re-establish fighting inflation as its top priority. And the Bush fiscal package, which will add further stimulus starting mid-year, makes monetary policy even more complicated.
Impact on Canada
Where does this leave Canada? Exports to the United States are already stagnant. Canadian firms will feel the pressure to keep diversifying their sales globally, as they did successfully in 2006 and 2007.
However, we do not expect to see Canada import higher U.S. inflation. A flexible exchange-rate policy will allow the Bank of Canada to continue to set monetary conditions that are appropriate for Canada, anchored in the 2 per cent inflation target. Even if the Bank of Canada cuts short-term interest rates, as new Bank of Canada Governor Mark Carney has signalled, we expect a positive short-term interest-rate spread to be maintained vis-à-vis the United States. The combination of diverging inflation trends and a positive spread means the loonie will stay strong, adding to the competitive challenge facing Canadian exporters.
In sum, Canada should be able to manage, but not completely avoid, the negative consequences of any U.S. drift toward stagflation. But the risk of U.S. stagflation deserves much greater attention and scrutiny.
Glen Hodgson is senior vice-president and chief economist of the Conference Board of Canada.