“Whoosh, Whoosh, Whoosh.”
As the Tardis landed, the Doctor excitedly leapt out.
“Donna, welcome to the 1970s,” he exclaimed.
“But how do you know it’s the seventies, and why are we here?” screeched Catherine Tate, in a voice that could strip wallpaper.
“Don’t you recognise the signs? This was the age of glam-rock when men dressed as women. The Rolling Stones were taking the world by storm. Rocketing oil prices caused high inflation and falling economic growth at the same time. Donna, we’re here to defeat the Stagflation Monster.
“Doctor, I can see the Stagflation Monster, but look! Man United are the top football team, not Liverpool. We’re still in 2008, Doctor.”

Just like the Yeti and Elvis there’ve been plenty of reported sightings of the Stagflation monster over the years; there’s been a lot of talk recently that it’s already in America. But yesterday the Bank of England confirmed its existence in the UK and there are big fears that it could spread to Europe. So, if you’re in Ireland, keep reading, you could be next.

So what is stagflation? Grab a coffee and read on…….

The UK Quarterly Inflation Report In 30 Seconds
The Bank of England warned that the UK is in for two years of economic pain. Growth is likely to fall to around 1% by the end of this year. But rising food and energy prices will send inflation way over the target range, possibly hitting 4%. A recession in the UK isn’t forecast, but remains a possibility. Under these circumstances further rate cuts would be hard to justify.

What is Stagflation?
It’s not the rising cost of a stag weekend in Dublin. Stagflation describes two economic conditions that, prior to the 1970s, were thought unlikely to ever occur together. These are stagnation (slow economic growth and rising unemployment) and inflation (rising prices).

Stagflation is a period when low economic growth and rising/high unemployment happen at the same time as rising prices (stagnating growth and inflation).

Back To The Classroom
Let’s take the tardis back to class and look at the two parts in a bit more detail:

Slowing Growth
The first part is stagnating (or slowing) economic growth. In simple terms a country isn’t producing or consuming enough. In even simpler terms people aren’t buying as much as they were. In turn, if companies aren’t selling as much then they don’t need to produce as much, so they cut production. And if they’re not producing as much, and not selling as much, they don’t need/ can’t afford as many workers. So they get rid of them. The people that lost their jobs suddenly don’t have as much money so they spend even less. Imagine this continuing throughout different industry and service sectors and that’s your slowing growth.

Now common sense might tell you that if companies are selling less and laying off workers the last thing they are going to do is raise their prices. However, read on…..

Rising Prices
Inflation is the rise in prices of goods and services over time. It makes the pound, euro or dollar in your pocket worth less, as it can’t buy as much of the same product at the higher price.

There are two main causes of inflation. The first cause is directly linked to the concept of supply and demand; too much money chasing a limited supply means that people will be willing to pay more for the product (think Nintendo Wii at Christmas).

The other cause of inflation is from the rising cost of raw materials. This is top of the polls at the moment with massive rises in oil, metals and soft commodities like wheat and grain. Companies often have to push up prices even if demand is slowing. So in the UK and US there is probably stagflation, in Europe if growth slows we’ll be there too. The rise in oil prices has affected you and I through higher petrol and energy costs.

The CPI is the main, harmonised measure used throughout Europe (and the US). It excludes lots of things that rise in value like house prices and council tax and attaches much lower weightings to food and drink. That’s why it’s our lowest level of inflation.

There’s also the Retail Price Index (RPI). This is an old UK measure that includes mortgages. It’s the one used for adjusting lots of welfare benefits like pensions and child benefit in the UK.

The Missing Link
Over the years clever people have worked out simple solutions to simple problems:

Stagnation (slowing economic growth) can be solved by cutting interest rates and/or spending more government money. This increases growth. Think of the earlier spiral in reverse. Lower interest rates means lower mortgages while government spending means money is paid to road builders, IT companies and spin consultant/ make-up artists, all of whom have to employ more people. We have more money, so we spend more. Companies produce more so they employ more people etc, etc.

Inflation can be solved by the reverse policies. Raising interest rates, and/or putting up taxes, takes money out of the loop. The theory is that with less money chasing goods and services, prices will stop rising.

But, as the good Doctor says, here’s the real bugger. What do policy-makers do when confronted with both slowing growth and rising prices?

As far as the central banks go, how much of a rat’s arse they give depends on their job description. The European and UK central banks are mandated solely to keep inflation under control. However, the US central bank has a broader job spec to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates, but with no specific inflation target.

So, the European and UK central banks should be committed to keeping interest rates at a level to keep inflation under control. The US Federal Reserve has the wider remit, and stronger political pressure to manage the growth side as well.

As things stand, inflation in the US is 3.9%, Europe is 3.3% and in the UK it’s 3%. Growth is currently estimated at 0.6%, 2.2% and 2.5% respectively.

The US government announced a stimulus package very early on, but then it’s election year over there. In the UK the finances aren’t good enough to allow a fiscal stimulus (throwing government money at the economy). This would be the normal policy for curing slowing growth but Gordon Brown’s already blown all the money on….actually, what has he blown it all on? And the Eurozone will be in recession before all the different countries can agree on what to do to solve the problem.

So How Does The Doctor Defeat The Stagflation Monster?
It’s a real dilemma; which is the greater evil, slow growth or higher prices? The first ultimately leads to more people without jobs and having less money; the latter option means people still have their money, but its spending power is reduced (a sort of fool’s gold).

Back in the 1970s, the US tackled the Stagflation Monster by concentrating on inflation. First the government imposed price and wage freezes, but when this didn’t work they switched to using interest rates to beat the demon. The important point here is that this took several years of pain and suffering to turn the economy around.

This time, with the election fast approaching, the US approach has been to tackle growth first, then worry about inflation (better to keep the voters happy). By contrast, the European approach has been to bear down on inflation, which will eventually allow interest rates to fall. And the good old UK is either following a happy compromise, or is just plain confused.

I reckon we need more than the good Doctor, armed with a magic screwdriver and a screeching assistant, to save us from this one.

Me? I’m happy trading as a grizzly bear in these conditions. I’m already short of the FTSE, but waiting for investors to wake up and smell the coffee before increasing my bet.