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Tuesday, August 26, 2008

Next Stop Stagflation?

The economy is entering a very dangerous time, and what could be the result is something we haven't seen since the end of the 1970's, Stagflation.

Stagflation is an economic situation in which inflation and economic stagnation occur simultaneously and remain unchecked for a period of time.[1] The portmanteau "stagflation" is generally attributed to British politician Iain Macleod, who coined the term in a speech to Parliament in 1965.[2][3][4] The concept is notable partly because, in postwar macroeconomic theory, inflation and recession were regarded as mutually exclusive, and also because stagflation has generally proven to be difficult and costly to eradicate once it gets started.

Throughout the year, the economy has shown very miniscule growth. Strong growth is about 3% growth in GDP. So far this year the economy has grown 1.4% and just over 0% in the first and second quarters respectively.

Now, in the last couple months, there has been troubling news on th inflation front. A recent wholesale price increase has further stoked fears of rising inflation.

Wholesale inflation surged in July, leaving prices for the past year rising at the fastest pace in 27 years, according to government data released Tuesday.

The Labor Department reported that wholesale prices shot up 1.2% in July, pushed higher by rising costs for energy, motor vehicles and other products. The increase was more than twice the 0.5% gain that economists expected.

Core prices, which exclude food and energy, rose 0.7%. That increase was the biggest since November 2006 and more than triple the 0.2% rise in core prices that had been expected. The bad news on wholesale prices followed a report last week that consumer prices shot up by 0.8% in July, leaving consumer inflation rising at the fastest pace in 27 years.

Now, if we face a period of significantly rising inflation at the same time we have a shrinking economy that is an unmitigated disaster. Here is how we got to this point.

Once the housing market tanked in August of 2007, that began the quick slide toward a recession. Since then, the housing market has only worsened. Initially, it looked as though the crisis would be limited only to sub prime. Quickly it spread into Alt A, and now more recently, Fannie and Freddie are also in deep trouble. The economy is NOT going to recover in any tangible way until the housing market recovers. That appears to be a long way off.

In September of last year, the Fed, clearly freaked about the impending real estate crisis, began a series of aggressive rate cuts. I said then that this appeared to be too aggressive. By the time it was all said and done, the Fed dropped the Fed Funds rate to 2%. It was clear that the Fed was making a very dangerous bet. The Fed was betting that their aggressive rate cuts would stabilize the housing market and eventually the economy without dropping them so quickly that it put the economy into a period of inflation.

Instead, the bet lost on both counts. The Fed clearly didn't take any stock of the housing market before they began their aggressive rate cut. The housing market was in a state of chaos far more significant than any rate cuts could resolve. On the other hand, the rate cuts weakened an already weak dollar. This lead directly to explosion in both commodities like wheat and more importantly gasoline. As the Fed was going through their reckless rate cuts, nearly no one, short of Steve Forbes, dared to criticize their actions. Even as their action weakened the dollar and ballooned food and gas prices, you heard nearly no criticism.

As such, the Fed has put the economy one step from unmitigated disaster. Fortunately, there are easy and tangible steps that can be taken to remove the economy from its ledge. First, the Fed needs to begin raising rates at a slow, but, steady pace. Second, the Congress needs to make the tax cuts permanent. By raising rates, the Fed will strengthen the dollar which will put downward pressure on both gas and food prices. This should relieve most of the inflationary pressure from the market. By making the tax cuts permanent, that will give the economy the necessary tax stability necessary to create investment spending and consumer spending.

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