The S word that has businesses and bankers worried

Tuesday, 1 March 2022

Some fear a brief period of stagflation lies ahead: where prices go up while the economy contracts.

Dileepa Fonseka is a Stuff writer on business and politics.

OPINION: So far 2022 is proving to be the mirror image of 2020 for New Zealand: everyone’s getting Covid, there is no lockdown, and a recession with a side of stagflation is looming too.

The Alternative Board managing director Steve Wilkinson runs a business mentoring service for small to medium-sized enterprises in the South Island, and in recent months he has seen more and more business owners turn up to peer-mentoring sessions who are seriously thinking about selling up and moving on.

“The clients I'm talking about, they've all done pretty well … they're not going broke or anything like that.

“A lot of the decision-making that they need to make is out of their hands. And that creates stress. And you know, they start to lose energy levels.”

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John Carran says there is a chance the economy experiences a contraction quicker than is forecast currently.

These are not businesses in pandemic-struck sectors like hospitality or tourism, but they are still affected by the wide-ranging and ever-changing polices that accompany Covid-19.

However, with both interest rates and inflation on the rise, there soon might be another reason business owners decide to cash out.

Jarden director of wealth research John Carran uses the “S” word to describe the potential economic danger we face.

That word, “stagflation”, refers to a painful period of high inflation coupled with a recession.

Carran says the last bout of it, during the 1970s, ran for only about a year in New Zealand, but the experience of it was so traumatic it has been etched into the memories of those who lived through it.

Overseas commentators are fretting about the possibility of stagflation too: earlier this year The Times referred to stagflation as “the 1970s revival nobody wants”.

Normally, high inflation is a sign of growth running unsustainably hot, which means rising prices but with low unemployment and higher wages.

Steve Wilkinson says a lot of businesspeople are tired from Covid-19, and already exploring their options to cash-out.

Stagflation is where inflation rises while the economy shrinks.

In an inflationary environment, people have plenty of money to spend, but there is just not enough capacity in the economy to deal with their demands, so they keep bidding prices up.

The reason people like Carran see stagflation as a possibility is because so much of the current bout of inflation is tied up in supply chain or border-related issues, from shipping delays to the inability to bring in migrant workers.

To clamp down on that inflation the Reserve Bank has adopted a hawkish stance, which means it intends to raise interest rates multiple times this year at a higher level than it indicated earlier.

By hiking interest rates you cut back demand, and stop people growing accustomed to continually rising prices, but it comes at a cost: higher levels of unemployment, or less money for workers, as firms cut back to accommodate a reduction in demand.

David McLeish says households are much more indebted than they were during the last aggressive hiking cycle.

The inflation part of stagflation comes when prices keep rising even though you’re raising interest rates, leaving workers with more job insecurity as prices continue to skyrocket.

Ironically, the major reason Carran thinks we might avoid this scenario is because he suspects the Reserve Bank of New Zealand will not keep raising rates.

“As we progress through this year, the data will start coming a bit weaker, and they may start softening their stance.”

Similar predictions are being made overseas.

When people think interest rates will rise, they start to invest in a set of financial products that 'embed' those expectations.

Fisher Funds head of fixed income David McLeish has been watching those products both here and across the globe, and says global markets are predicting central banks won’t stick to their interest-hiking guns, especially in the United Kingdom and the United States.

“Those financial products suggest … this [interest rate] hiking cycle that will occur this year will cause their economies to tip over into some form of recession within the next couple of years,

“And therefore, those interest rate markets are expecting those central banks to start cutting interest rates, again.”

That expectation is muted in New Zealand because market participants don’t think the economy will contract so substantially that the Reserve Bank will reverse course.

McLeish thinks other market participants have underestimated the powerful effect interest rates have on the New Zealand economy.

It all comes down to household indebtedness and how wedded consumer demand is to rises and falls in house prices.

McLeish points to the important part low interest rates have played in stoking house prices, causing an economic upswing that defied earlier expectations.

So, if interest rates cause such a bubble on the upside, McLeish argues they could cause a severe contraction on the downside.

“I think, that [interest rate rises] will be a factor that will dramatically slow our economy, and I don’t think that is appreciated by markets.”

This past year has shown us the consequences of pumping too much stimulus into an economy, especially when it comes to asset prices and inflation, but we shouldn’t forget that over-correcting for inflation has consequences too.