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Wednesday, February 20, 2008

The Fed's Economic Conundrum

The Fed Chairman spoke today and offered a gloomy outlook for the economy.

The Federal Reserve said Wednesday it had lowered its U.S. economic growth forecast for 2008 to between 1.3 and 2 percent due to the deepening housing slump and tight credit and said risks of further setbacks were troubling.

"The possibility that house prices could decline more steeply than anticipated, further reducing households' wealth and access to credit, was perceived as a significant risk to the central outlook for economic growth and employment," the Fed said in its quarterly forecast.

At the same time, the latest inflation numbers came out and they offered signs of problems there to.

U.S. inflation accelerated in January in a worrying sign for the Federal Reserve's campaign to bolster the flagging economy, while a separate report on Wednesday showed more troubling signs for beleaguered housing market.

Annual consumer price inflation increased to an unexpectedly strong 4.3 percent in January from an already elevated rate of 4.1 percent in December, according to the Labor Department.

Now, these latest inflation numbers are only one month and everyone should be careful to draw too much conclusion. That said, if they offer a trend then the Fed is facing a conundrum. The Fed may in fact be fighting off a softening economy at the exact same time they are facing rising inflation. The worst case scenario for this stagflation, a recession combined with high inflation.

The rub, as Shakespeare would say, is that treating one will perpetuate the other. If the Fed focuses on the recession they will perpetuate inflation and vice versa.

At this point it is still unclear which, if either, is the problem or maybe the bigger problem. It is clear that the Fed sees a looming recession as the bigger problem as they have aggressively been dropping the Fed Funds Rate for the last several months. It is furthermore unclear what that rate drop will do to inflation, or if it in fact perpetuated the high inflation number we have.

While the Fed is projecting a softening economy, it is important to note that they aren't projecting a recession. While the GDP growth is supposed to slow down, the Fed is predicting continued growth. (A recession is two straight quarters of negative growth in the GDP) Either way, in the next several months the Fed Chairman, Ben Bernanke, will earn his money so to speak.

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