I’ve heard the term “stagflation” mentioned a few times in recent weeks. It is such a strange concept. It means that whilst an economy is slowing and unemployment is rising, the rate of inflation remains persistently high.
In theory, stagflation shouldn’t really exist. If we think about it logically, if an economy is slowing, then it should mean that aggregate demand is low. Consequently, it should also mean that prices should be falling rather than rising.
So, how is it even possible that prices can rise when demand is on the wane. It just doesn’t make sense. Similarly, if the rate of unemployment is rising, then shouldn’t the cost of labour fall. It doesn’t make sense that wages should rise when more people are out of work.
Whether it makes any sense or not, the world could be entering a period of stagflation. We are not quite there, yet. However, if central banks should continue with their focus on driving down inflation, then stagflation could be a strong possibility.
But that is not the only piece of bad news. Even worse than stagflation is that there is no known cure for stagflation. If central banks should try to stimulate economic growth, then inflation could take hold. But if central banks should pursue their goal to rein in inflation, then the economy could suffer.
That could help explain why central banks are prepared to do nothing, at least for now.
In September, a raft of central banks decided to leave interest rates unchanged. These included the Fed, the Bank of England, and the Bank of Japan. In Asia, Bank Negara Malaysia, the Philippines central bank, the central bank of Indonesia and the Taiwan central bank all sat on their hands.
Admittedly, inflation does look to be heading lower. But all is not exactly quiet on the inflation front. Oil prices are heading towards $100 a barrel, rising food prices are back on the agenda, and workers are asking for higher wages. It might not take too much to send inflation back up again.
If that should happen, central banks may be left with no option but to hike rates again. In a recent interview, Jamie Dimon, the boss of JPMorgan Chase quipped that the world may not be prepared for interest rates at 7%.
That could be the understatement of year if the Fed should hike interest rates by another two percentage points. It could unleash the mother of all economic downturns.
Whether the Fed will or won’t go that far is a moot point for investors who are focussed on solid income-generating shares. These are shares in companies with pricing power.
They can survive in harsh economic conditions. They have strong free cash flow. They should be the workhorse of any well-balanced portfolio if we want to achieve our investment goals.
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