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Inflation And Economic Growth: A Tricky Call

Rob Mackrill - Tue 13 Nov, 2007

You could have high inflation and low unemployment. Or you could have the opposite - low inflation and high unemployment. The idea surfaced from economist Alban Phillips, who explained the relationship in a graph, the Phillips Curve. As it turned out, it was wrong. A slightly different economic choice presents itself now. On one side is still inflation - but on the other is economic growth.

They’re incompatible. You can have one or the other.

In the days when Keynes cornered economic thought, the view prevailed that inflation and unemployment were opposing characters never to be found in the same room together.

You could have high inflation and low unemployment. Or you could have the opposite – low inflation and high unemployment. Policymakers couldn’t have both. They had to choose.

The idea surfaced from economist Alban Phillips, who explained the relationship in a graph, the Phillips Curve. As it turned out, it was wrong. Along came stagflation in the ‘70s with high unemployment and high inflation and economists scratched their heads and swiftly dumped the idea.

A slightly different economic choice presents itself now. On one side is still inflation - but on the other is economic growth. Central bankers will wish to steer a steady course with the two but getting the balance right between rising prices on the one hand and a sagging economy on the other is a tricky call. Ben Bernanke said as much last week.

Cutting interest rates helps out business and a hard-pressed housing market, but it doesn’t help fight inflationary pressures stirred up by frisky commodity prices feeding through the factory gate into higher consumer prices. Not cutting interest rates risks derailing the economy and provoking possible meltdown in brittle asset prices. Only this morning, for example, a survey from the Royal Institute of Chartered Surveyors says UK house prices are falling at their fastest since 2005.

As it is, UK factory gate inflation hit a 12 year high in October at 3.8% against 2.8% for September. Plus rises in food and oil prices have seen the latest CPI number rise back over the Bank of England target at 2.1% for October against 1.8% in September.

The rise was ‘unexpected’, reports Reuters which seems a little surprising when you think we are now living with $90 dollar oil, a 35% milk price increase and two bread price increases in the past two months, amongst other basics.

And on the subject of $90 oil...

“15c a cup, is not expensive in a declining resource.”

So says Matt Simmons of Simmons & Co on Bloomberg yesterday. Houston-based Simmons is a veteran of the oil industry, an adherent to the ‘Peak Oil’ theory and author of Twilight in the Desert, a book about the decline of Saudi oil production. (A compelling read, by the way, and highly recommended.)

Simmons is increasingly convinced global production has peaked and the oil price will keep going up. ‘[Oil production] peaked in May 2005 and we have been living on borrowed dreams ever since’. You can catch more of his views here.

Simmons dismisses Tupi, the recent major Brazilian offshore oil discovery as ‘important but just a dent’ in the problem. The deep water field has only drilled two wells, is extremely complex, and might not even be commercial. Even if it is, it will take 5-10 years says Simmons.

And don’t expect production shortfalls to be covered by Saudi Arabia this time he adds. Saudi has no excess capacity. It has no more spare oil and is not able to increase production in a meaningful way. Demand for oil is growing far faster than anyone thought.

Not encouraging news for the inflation outlook.

*** News from Blackstone, the American private equity firm that floated in June.

Announcing third-quarter revenues up 14% which missed analysts estimates its president; Tony James says the residential mortgage mess is a “deeper, darker, scarier” black hole than anyone on Wall Street had anticipated.

More uplifting news tomorrow…

Regards,

Rob Mackrill
The Daily Reckoning UK

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