Stagflation Risks Linger in Four Major Economies

As the global economy continues to struggle with a weak recovery, the question is whether the age of deflation will now be replaced by stagflation? 

In the final quarter of 2014, the Organization of Petroleum Exporting Countries made a decision not to limit oil supply amidst rising competition from the US shale oil production. As a result, oil surplus weighed down on fuel prices in the global market, Seeking Alpha reported. 

For the next two years following that decision, fuel prices were on a downtrend losing more than 60% (at their lowest point) of their value from their peak in 2014. But fuel is not the only commodity that has seen falling prices in recent years. Steel has seen some major drop in prices from 2015 to 2016, and at its worst, lost 75% of its value. Other industrial commodities such as iron and copper suffered the same fate as weaker demand resulting from the global financial crisis persisted.

But the recent move from OPEC is about to change the inflation trajectory. In the final quarter of 2016, OPEC members agreed to a supply cut of 1.2 million barrels per day followed by an additional cut of 560,000 million bpd from non-OPEC member nations. The initial market reaction led crude oil prices to $50 bpd and went up further to $54 bpd before the close of the year. 

The following looks into the stagflation risks in the US, Eurozone, China and Japan.

USA

Deep in its recession, USA fell into deflation in 2009. As the economy recovered, so did prices. In 2015, US fell to a mild deflation in the first quarter mainly as a result of fuel price movements in the global market. But the deflation was short-lived as the year marked the strongest economic growth since the financial crisis. But, the living standards of the US middle class in the past eight years have declined.

But 2016 felt the burden of the higher interest rate and the absence of quantitative easing. Consumer spending growth has decelerated and so did economic growth, with the full year expecting an average growth rate of 1.5%. If the recent trend is to be followed, rate hikes will simply dampen economic growth but not inflation potentially leading to stagflation. 

Eurozone

Similar to the US, the Eurozone has yet to fully recover from the financial crisis of 2009. With the area continuously weighed down by troubled member-nations, economic growth has remained anemic barely escaping a contraction. In 2009, the economy suffered a sharp recession averaging 4.5% and with it came deflation. While a recovery ensued the following year, it was short-lived as the area reverted back to a recession in 2012 and 2013.

In 2016, periods of deflation have been recorded despite positive economic growth. Following OPEC's announcement in the fourth quarter, inflation jumped by more than 1%—the highest in two years. Despite the acceleration in prices, economic growth is stagnating at 1.7% while unemployment remains significantly high at an average of 10%. 

Brexit threat did not affect growth significantly but will most likely create a negative impact in the next two years. 

Japan

Japan has struggled with deflation for more than a decade prior to the financial crisis of 2008. When Japan was hit by a recession in 2009, deflation resurfaced soon after and lingered persistently for more than three years. The economy was on its way to recovery when the 2011 Tsunami occurred, stunting growth and changing its general trajectory. 

In order to combat an ailing economy, Prime Minister Shinzo Abe embarked on a series of fiscal expansion, monetary easing and structural reform. Economic growth breached 2% in the years following the expansionary policies but deflation lingered as consumer spending remained cautious. 

With a target inflation rate of 2%, Abe decided to raise the sales tax which has the ability to augment their worsening fiscal stance and raise inflation. But the sales tax hike resulted in a sharp drop in consumer spending paired with a higher inflation rate. In the absence of a strong demand, the nation fell back to deflation as global fuel prices began to decline and the effect of the sales tax hike has leveled off.

In 2016, deflation averaged -0.2% as a result of the weak economy, weak spending and weak commodity prices in the global market. 

China

For China, the financial crisis resulted in a slowdown as the nation recorded its first single digit growth rate in nearly a decade. Despite the slowdown, China's economy managed to sustain an enviable growth especially for nations under a recession. Even with a relatively stronger growth, China did not escape deflation. In 2009, prices fell at an average of 0.7% reinforcing speculation that growth is hardly driven by domestic demand. 

China's slowdown is expected to continue in 2017 as they continue to reduce overcapacity, cut inventories as well as production costs. Economic growth is expected to run at 6% to 6.5% for the year, while inflation target remains at 3%. 

Among the nations mentioned above, stagflation risks are strongest in the Eurozone and Japan. Both nations have negative interest rates that may be raised to diminish the acceleration in inflation.