Fed Struggles With Stagflation

John Browne
Tuesday, Jan. 22, 2008

It is now increasingly apparent that the economic virus of stagflation — one that I have warned about consistently since early last year — is now virtually upon us.
Stagflation is the simultaneous presence of two apparent economic opposites — financial inflation and economic recession — something that is confusing to everyone: to businesses, to investors, and to our government and Federal Reserve Board.

The treatment for inflation is higher rates. Recession requires the opposite, lower rates.

As Newsmax Publisher Christopher Ruddy recently reported, "Just a few weeks ago, the U.S. Labor Department released startling inflation news: Intermediate goods prices up! Producer prices up! Consumer prices up!"

In fact, consumer prices rose by 4.1 percent in 2007, up from 2.5 percent in 2006, to a 17-year high!

And these are the official figures, which we have long known to be cooked to the downside. "Real" inflation — as it's felt on Main Street, where people actually eat food, use oil and use medical services — is far higher.

What never ceases to amaze me is Wall Street's ability to believe our government's figures and to focus exclusively on modest increases in the monetary base. Meanwhile, they ignore the leverage of bank lending and the massive use of leveraged derivatives — all in order to deny the reality of Main Street inflation.

The result is that the yield spread on Treasury Inflation Protected Securities (TIPS) over conventional Treasuries and over the long-term bond markets shows little indication of inflationary pressures. There appears to be a worrying disconnect between the bond market's view and the actual experience of Main Street.

Despite the outlook for lower earnings, the stock markets are still prone to false optimism at the mere thought of lower rates. So there appears also to be a disconnect in the stock markets.

That disconnect, with the prospect of lower earnings, calls for lower interest rates to increase the present value of the lower income streams they see in the future.

On the recession front, the unemployment figures are a cause for real concern, as is an average job-waiting period of 16 weeks. Worrying, too, is the near-stagnant wages of the past decade and the threatening overhang of $300 billion of possible mortgage defaults and $100 billion in potential credit card defaults.

The specters of simultaneous inflation and recession are both bad — very bad, particularly considering election-year politics.

Although rampant inflation may do more long-term economic damage, it is recession that is the more visible politically and, therefore, seen as the most damaging in the short-term, particularly in an election year.

I therefore feel that politicians will concentrate first upon us getting out of recession, leaving inflation and the fate of our dollar for later focus. Soon, they can be expected to put great pressures on the Fed to halt recession, despite that body's alleged political independence!

With both financial inflation and economic recession increasingly apparent, the Fed is in a fix. What should it do? Raise rates to kill inflation, or lower them to prevent recession — and risk sending the U.S. dollar into free-fall?

Well, the recent Fed's Beige Book report appears to be preparing the way for cuts. In that report, the central bank commented that economic activity increased at a slower pace, added to disappointing holiday sales and weak auto sales.

It went on to say that, "residential real estate conditions continued to be quite weak in all districts. Most districts cited tighter credit standards."

Despite growing evidence to the contrary, the Beige Book reported that "inflation concern is receding." In my view, this was a statement made in clear preparation for lowering rates. Indeed, only last week, in another preparation of anti-recession ground, Fed Chairman Ben Bernanke said more rate cuts "may well be necessary."

So, the Fed appears at long last to be poised to lower rates, even aggressively. The 2-year Treasury note currently stands above par at 101.422, yielding just 2.5 percent — another indication of an expected rate cut.

In addition, stock markets are crying out in increasing desperation for rate cuts.

These calls bring significant psychological pressure on the Fed. If stock markets continue to fall, consumer wealth will be eroded still more, adding to the fall in home values. That would tend to cut demand even further.

At its meeting next week, the Federal Reserve Open Market Committee (FOMC) will struggle not only with somewhat confusing economic data, but another problem as well. On one hand, countervailing stagflation pressures of inflation (plus defense of the dollar) will call for high rates. Yet, on the other hand, a potential recession calls for urgent and sharply lower rates.

However, if I were asked for an observation about the Fed, it would be my concern over the serious absence of a suitable sense of urgency.

It is common knowledge that a Fed rate cut will take between one and two years to gain economic traction. Meanwhile things are likely to go from bad to worse. Prompt and meaningful action is required from the Fed — right now!

I believe that the Fed may well lower its key interest rate this January, even at a "special" meeting following the GDP figures for the fourth quarter of 2007.

But, in my view, it will most probably be too little, too late to avoid our economy moving into recession in 2008.

http://moneynews.newsmax.com/money/arch ... 080235.cfm