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US Economy, Bernanke's Big Battle with Stagflation

Economics / Inflation Mar 30, 2007 - 10:40 AM GMT

By: Money_and_Markets


Mike Larson writes : Last week, I told you that our Federal Reserve Board Chairman was reaching for his “Bernanke put.” But today I want to talk about the major forces opposing his efforts.

In a nutshell, the Fed played too fast and too loose with monetary policy for too long. That allowed inflation to seep into virtually every corner of the U.S. economy and its capital and commodity markets.

At the same time, economic growth is slowing sharply due to the spreading impact of the housing and mortgage meltdown. I'll share some figures with you in a minute. Suffice it to say, they don't look good.

Put it together, and you'll see the Fed faces the worst of both worlds — heightened inflation and a slowing economy. In fact, it sounds an awful lot like 1970s-style stagflation!

The U.S. Economy Is Going “Stag” …

When I'm sitting here in my trading turret, I spend a lot of time staring at two Bloomberg screens. They're an indispensable tool when you live and breathe the financial markets.

One of my favorite functions allows me to see all of the latest economic reports in the U.S. I can review the actual numbers when they're released, the consensus forecast from economic experts, and more, all in one place.

What have I been seeing lately? Virtually every single line on my screen shows things coming in worse than expected .

  • Durable goods orders for February? Up just 2.5% versus a forecast for 3.5% growth.
  • The Richmond Fed's manufacturing index? -10 vs. a forecast for -5.
  • Consumer confidence? It's all right there on my trusty screen. The “actual” column shows 107.2 while the “survey” column reads 108.5.

March Empire manufacturing? Worse. February new home sales? Worse. February retail sales? Worse. It goes on and on and on.

My take: A STAG gering housing market is causing the economy to STAG nate. Here's how it's happening:

Slowing home sales and slumping home prices are making people less confident, and less likely to cash out money from their home equity.

That's causing overall retail sales to tail off. Retailers are responding by cutting orders. Factories are then forced to cut back on manufacturing.

Meanwhile, homebuilders are trying to adjust to lower levels of demand. They're curtailing construction activity and laying off workers they no longer need. More lost jobs are coming from other industries related to housing, like mortgage lending and real estate.

Add it all up and you've got a stagnating economy. Sure enough, the latest GDP growth figures, released yesterday, showed that the economy expanded just 2.5% in the fourth quarter of 2006. That's the third quarter in a row of lackluster growth.

However, a slowing economy is just half the story …

Don't Ignore the “Flation” Part of the Equation!

The U.S. might be weak, but global economic growth remains strong:

China's economy surged 10.7% last year. Factory output is jumping and consumer spending is going gangbusters.

Japan is firing on all cylinders. As Tony pointed out in “ Great Bargains in Japan ,” the country's real estate prices rose for the first time in 16 years in 2006.

Even Europe is getting in on the act. The 13 nations that share the euro currency saw their collective economy expand 2.6% last year. That was the most since 2000!

All this global growth is leading to a big surge in demand for commodities and other goods and services. And that means higher inflation.

Central bankers are supposed to react by tightening monetary policy enough to choke off that inflation … but they're not!

The Fed chickened out of further rate hikes nine months ago. Other central banks are sticking with namby-pamby, clearly telegraphed mini-hikes. That's allowing those price gains to become hard-wired into the global economy. [Editor's note: See “ Money, Money Everywhere ” for more on the effects of poor central bank policies.]

The result: Inflation is not receding. If anything, it's getting worse.

Everything from the Producer Price Index to the Consumer Price Index to the 10-year Treasury Inflation Protected Securities, or TIPS, spread confirms it.

Heck, the Fed's favorite inflation gauge has been at, or above, the top of the Fed's 1% to 2% “comfort zone” for more than two years! And the most recent reading on core inflation was even worse — 2.7%.  That doesn't even include the impact of rising crude oil and gasoline prices. In case you didn't notice, crude just surged back above $66 a barrel — up a hefty 32% from its January low!

To top it all off, respondents who were polled by the Conference Board just a few weeks ago said they expect future inflation to run around 4.9%. That was up from 4.8% a year ago and the highest reading since October 2006.

But you know what? The Fed doesn't want to level with us about it. This week, Bernanke told the Joint Economic Committee in Congress,

“Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems likely to moderate gradually over time.”

He went on to say that public perceptions of inflation “appear to be contained.”

As I've just told you, there is no evidence core inflation is coming down. And the most recent readings show both bond traders and the public are even more worried about inflation than they were a few months ago.

The Fed is clearly painted into a corner. Bernanke's trying to use that put , but powerful forces are getting in his way.

Three Steps You Can Take To Protect Yourself …

First, consider investing in countries that aren't facing the same problems. Martin has told you all about the economic boom in Brazil. Larry has shared some amazing stats about China. And Tony just told you how undervalued Japanese stocks are, and how that country is in a totally different economic situation than the U.S. There are plenty of great opportunities overseas.

Second, please, please, please stay the heck away from long-term bonds. The 30-year bonds are down almost three points in the past month, a clear indication that the market thinks the Fed's “contained inflation” talk is a bunch of bunk. Instead, stick your fixed-income money in short-term Treasuries, which don't get hit anywhere near as much as long-term debt when rates rise.

Third, beware of stocks that are sensitive to interest rates. Just look at what's been happening to the home builders. They're tanking almost every day now on a combination of slowing home sales, rising home inventories, tighter mortgage standards and now, rising long-term rates.

Until next time,

By Mike Larson

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