The Dreaded Word 'Stagflation' Makes an Appearance

Just when it seemed things couldn't get any worse, they did. The Federal Reserve Board's economists revised their growth estimate down, and their inflation forecast up. The dreaded word "stagflation" has begun to make its appearance, reminding those Wall Street analysts old enough to remember that in the 1970s the economy experienced 15% inflation, 9% unemployment and three recessions.

Those who want to update their financial vocabularies further should also take note of the new buzz word, "contagion", used to describe the fact that sub-prime problems are spreading to other parts of the closely interlinked credit market, such as credit cards and non-sub-prime mortgages.

Add "decoupling" to your lexicon and you will be au courant: analysts who confidently predicted America's problems would not spread, are now less certain that the US economy is decoupled from the rest of the world. That's why BNP Paribas economist Ken Wattret said that "all the reliable leading indicators of eurozone economic growth point to even worse news ahead".

And why Mario Draghi, governor of the Bank of Italy and head of the Financial Stability Forum, said of write-downs by Europe's banks, "it's not over yet". After all, led by London's bankers, European institutions probably put as much into the sub-prime market as American banks did, and have yet to write off most of the bad loans. Credit Suisse, which first proudly announced that it had suffered only minor damage from turmoil in the credit markets, was forced a few days later to confess it had not noticed a $2.85 billion loss from trading in the debt markets. This added to the pervasive feeling of uncertainty: if Credit Suisse didn't know its true exposure when reporting its earnings, there must be others that have merely shaved the tip off the iceberg of bad debts lurking below the surface of their published figures.

Now for the bad news. Consumer confidence is at its lowest level since the early 1990s; "There is not much doubt in my mind that the US economy is now in recession," well-regarded Goldman Sachs economist Jan Hatzius is telling the firm's clients; The jobs market is weakening, and may even be contracting. Which is bad news indeed because "pay-rolls don't just edge lower in a recession . . . they drop like a stone," reports the Business Week economist James Cooper; The Fed's minutes report that "recent data . . . indicated that consumer spending had decelerated considerably".

Now for the really bad news: last week oil prices pierced the psychologically significant $100-a-barrel level for the first time, not counting one deal on January 2 by a trader eager to become a footnote to history. This caught a lot of speculators short, as they expected prices to slide, and settle between $85 and $90. After all, several indicators suggest a weakening in demand. The International Energy Agency (IEA) recently cut its forecast of 2008 demand to reflect predictions of economic slowdown in America, and petrol demand is falling in the US. Meanwhile, inventories of crude oil are rising. The much-followed Schork Report said it expected crude supply to outpace demand for the "next couple of weeks".

Yet prices are rising. On the demand side, despite the lowering of its forecast, the IEA still expects China, India and other emerging economies to drive up worldwide demand by something like 2%. And many observers expect the cheques to be issued as part of President Bush's stimulus package to reach consumers by early summer, just in time to offset any pressure Americans might feel to cut down on petrol during the driving season.

Even more important are developments on the supply side. Markets were temporarily rattled when Venezuelan president Hugo Chavez threatened to cut off oil supplies to the US, despite the fact that America has about the only refineries capable of using his country's very low-grade crude, and that he is desperate for funds. But production in Venezuela continues to decline, as much-needed investment is diverted to Chavez's welfare projects. Also, some 10% of Nigeria's oil production has been cut off by rebels.

Most important of all, Opec, which accounts for about 40% of world output, refuses to lift its production ceiling, despite personal pleas to the Saudis from Bush. The Saudis seem to have adopted the "a friend in need is a pest" attitude. Opec fears an economic slowdown will cut into demand, and that the dollar will fall further, reducing the purchasing power its cartel members receive in return for their oil.

The longer-term problem stems from the refusal of many nations to open their oilfields to exploration and development by western firms. With high prices producing as much money as even the producing countries can reasonably spend and invest, they have no compelling need to bring new supplies to market. Besides, if they want to increase the flow of cash, they can always insist on renegotiating the deals signed with western countries, giving credence to the observation that a contract with an oil-producing country is the first round in a negotiation.

At last, the good news. Last week a leading investment banker told me that his firm's clients were making money, had good cash flows, and were earning about 20% returns on their businesses. Businessmen I talk with, though concerned about what might lurk just round the corner, report healthy sales and satisfactory profits. I can't help feeling that the health of the firms on the sharp edge of the economy tells us more about our future than the problems of accident-prone bankers and investors who forgot how to price risk.