US Recession with Inflation or Deflation?

By: Bruce_Allen

"One foot on the brake and one on the gas, hey! " --Sammy Hagar, "I Can't Drive 55"

It's the summer of 2008 in the U.S. .  Recession is imminent, if  not already here, and debate rages as to whether it will be accompanied by inflation, giving us that 70's show--stagflation.  Most respected economists insist the inflation risk is small; a number of others think it's high. We examine the arguments, dividing them into Things We Know and Things We Suspect.

Things We Know

• Commodity prices, notably oil, have corrected, but are still trending above historical averages.  Global demand is growing. 
• The Fed Funds rate currently stands at 2%.  Money is about as "easy" as it is ever going to get, but it's hard to get a loan.
• Consumer prices in June rose at an annual rate of 9.6%. YOY CPI increase in June was 5.6%, the highest in 18 years.
• The U.S. unemployment rate in June moved from 5.5% to 5.7%.  
• The dollar, having recently corrected, has declined over 25% against major Western currencies since 2003.  
• Households are spending more of their budgets on food and gasoline, and less on fun and games.  
• In 2007 the average American home lost 15% of its value, and people feel poor.
• The housing, banking and automobile sectors of the economy are in distress.
• The Federal deficit last fiscal year was over $500 billion, twice the projection of 18 months ago.  Plus the "off-book" stuff that escapes inclusion in these figures.
• The trade deficit last year was over $700 billion.
• Consumers are adding to their credit card debt, despite the arrival of tax rebate checks in the spring and summer. See graph below.
• There will be a new president in the White House in January.

Things We Suspect

• There is some speculation in commodity markets--hedge funds at work. Regulate 'em.
• The people who invented, packaged and sold CDOs for sub-prime mortgages successfully pulled off the largest "pump and dump" scheme in history--maybe $2 trillion in downstream equity gone for a long time. The greatest "negative wealth effect" event since the 1930's. The sludge is spilling over into commercial and consumer banking.
• Inflation has yet to fully arrive in the economy.  It is en route.  Watch food prices climb in the fall of 2008.
• In response to higher costs, businesses will have to raise prices or lay people off.  Lack of pricing leverage is likely to favor layoffs.  Unemployment is likely to continue to rise--in an election year.  No pre-election pork this year.
• If Israel bombs Iran a barrel of oil will jump $30 in one day, and the Dow will drop 1000 points.
• A recession in the US is unlikely to slow the rising secular trends in world commodity prices.
• A recession in the US will increase government spending and reduce tax receipts, forcing the Fed to print more bullets.
• The Fed wants to choke inflation by raising short-term interest rates, but can't do so for fear of being thought insensitive.
• The new Congress and president will not stand idly by in January of 2009 and watch the economy stall.

Conventional theory suggests that one fights recession by lowering interest rates and applying a federal stimulus to the economy.  To combat inflation, raise interest rates and reduce federal spending.  If you have both recession and inflation concurrently, supporting one worsens the other, limiting the available policy alternatives.  Although there is plenty of room to raise interest rates, there is virtually no room to lower them.  With the deficit running at $500-600 billion, it is difficult to imagine much additional deficit-financed spending to stimulate the economy.  Nor is it easy to envision Washington suddenly reigning in spending in order to restore fiscal balance.  Then there's the $100+ billion a year going to Iraq ...  The U.S. could run a trillion dollar deficit in 2012.

The recession is here.  The debate is over inflation--will we continue to see it, or will it wilt in the face of "demand destruction" caused by a domestic recession and rising unemployment?  Will businesses be able to raise prices and increase the pay of workers whose real incomes are declining?  Or does the global economy make pricing power a thing of the past, forcing businesses to cut labor in order to pay higher energy bills?  Do Congress and the new administration knee jerk a fiscal stimulus, attacking the symptoms of the problem, rather than the problem itself?  The problem--being an internal combustion economy in the new world energy order.  It's a big problem, and it's much easier to attack the symptoms.

Global demand for commodities is a direct function of global GDP.  For a moment, consider the net effect on global demand given a serious deep recession in the U.S.--negative 3% growth, worst in a generation--coupled with a global growth rate down from its ten year average of 4+%, to 2%.  ( US demand declines by 3% and the rest of the world grows by only 2%.)

US GDP 2007   -3%                          $13.0 TRILLION X 0.97 =  $12.61 TRILLION
REST OF WORLD GDP 2007 +2%      $52.0 TRILLION X 1.02 = $53.04 TRILLION
                                                        $65.0 TRILLION               $65.65 TRILLION

Aggregate global demand increases, placing additional pressure on prices.  Even if the U.S. economy avoids recession and sticks the "soft landing,” expect global commodity prices to continue upward.  The correction of the summer of '08 is just that, the long expected retreat of the speculators.  They made their money when oil was above $140 and have left the building.  Plus, China has turned off Beijing for a month, instead pumping vast quantities of "air" into the local atmosphere. With limited storage capacity, the Chinese have reduced oil purchases since late July, coincident with the fall in prices.  They'll be back soon.

At the Fed, Inflation is Job #1.  They're itching to raise interest rates against inflation. Last time around they had to take Fed Funds to 14%. The result was a miserable recession in the early 1980s. The alternative is unimaginable, that the Fed will ignore inflation, leaving an inflating market unrestrained by higher rates.  Such a policy would increase federal and trade deficits, further reduce the value of the dollar, and shatter the bond market. Eventually rates are going to head back up.

The concern here is that the domestic economy will respond to rising interest rates with a deepening recession, but the global economy will continue to hum along, driving commodity prices and providing no inflation relief for American consumers. 

Expect the government at its worst this coming January.  The Federal Reserve raising interest rates.  The new president announcing his arrival by noisily implementing a megabillion dollar First 100 Days, smoking the tires. One foot on the brake, and one on the gas.

By Bruce Allen

http://www.clearconceptcommunications.com

Bruce Allen is a freelance writer and blogger living in Indianapolis . He has a BA from Washington University in St. Louis and a MS from Michigan State . He writes about macroeconomics, water resources, professional sports, motorcycle racing and fantasy basketball. Visit his website at www.clearconceptcommunications.com . Email bruce@clearconceptcommunications.com.

© 2008 Copyright Bruce Allen - All Rights Reserved
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