What is the Possibility of Stagflation

It has been an interesting year for the world economy. Over the last three months central banks around the world have undertaken a number of measures to forestall deflation and lift the global economy out of economic slump and credit crisis. Aside from traditional monetary policy tools such as official interest rate cuts and relaxations in reserve requirements, central banks have resorted to alternative unconventional tools. There has been measurable easing of the credit crisis, U.S. and Europe, who may be joined by other central banks as they too head towards zero interest rates in leaps and bounds

With monetary policy transmission broken by the unwillingness of the private sector to lend or borrow, central banks have had to scurry for alternatives to rate cutting in order to restore markets. They set up an alphabet soup of liquidity facilities that lend funds or purchase assets, offered guarantees on deposits and loans, and established currency swap lines, in addition to a host of fiscal stimulus packages announced by governments.

So are the pieces now in place to prevent global stag-deflation?

It is too soon to tell. So far, money market and commercial paper markets have shown tentative signs of easing. But elsewhere in the private sector credit market, tensions remain as asset prices move shambolically and de-leveraging drags on among households, banks and businesses. Though money supply has grown, the velocity of money has slowed despite the flood of liquidity from central banks and official interest rates effectively at or near zero. In other words, we have fallen into a liquidity trap. Such a blow to consumer demand makes deflation in 2009 a real possibility.

Despite liquidity raining down on the financial system from the Fed and ECB, the financial fires have yet to be extinguished.

Yes, money market rates are off their peaks and the commercial paper market contraction has bottomed. But a lack of confidence among lenders in potential borrowers (and a lack of confidence among potential borrowers given the profit or income outlook) and falling asset valuations has stymied significant easing in market interest rates, such as for mortgages and car loans. Rate cuts and quantitative easing notwithstanding, it seems the threat of a liquidity trap is looming on the U.S.

In the U.S., private demand continues to fall sharply as does the string of awful economic and financial news. Job losses continue to keep mounting, and U.S. GDP is expected to shrink 4% or more in Q4 2008 and the contraction is expected to continue throughout 2009. Orthodox and unorthodox monetary policy measures are certainly needed but they have to be accompanied by a significant stimulus on the fiscal side to support aggregate demand. The great retrenchment of the private sector balance is already under way and the new U.S. administration is getting ready to make the largest investment in infrastructure of the last 50 years. The details of the size and content of the stimulus package are not available yet. However, there seems to be a general consensus that a package of $700-$800 billion dollars is the expectation. This may be enough, but it will be tight as recession sweeps up the entire world.

Contraction is not out of the question in 2009