In one of those odd time warps in history inflation and a stagnant economy are coming together. Inflation is growing primarily because of the high price of oil and grain. The GDP is barely moving because of a credit market crunch and home prices which are in a flat spin downward.
The Fed has as much as admitted that it has to fight a two-front war now and that could call a halt to its dropping of interests.On the other hand lower money costs could fuel re-away prices.
Everyone is wrong on how to handle stagflation because the cure for inflation kills growth and vice-versa. But, it is certain that no one knows which will hurt the economy more because almost all economic models which look out a year or two are flawed, otherwise economists would be the most highly paid people in the world. Unknowns like war, hurricanes, foreign politics, and drought play too large an unanticipated role
That means that the Fed, and to some extent the Treasury and Congress have to pick which battle to fight and hope that they are right.
A deep recession is almost certainly a worse result than rising prices. An economy in shambles hurts employment and makes the housing crisis much worse. That, in turn, undermines financial derivative products based on home loans, credit cards borrowing and auto financing. A drop in those values could lead to a collapse of the mono-line insurance firms and another huge series of write-offs at banks.
More than anything else, elected officials hate to see people standing in unemployment lines. It is bad for the re-election odds and even politicians, some of them, have compassion
Fighting inflation means believing that the government can undercut the rising price of oil and commodities like wheat and corn. But, the chances of success in those arenas is doubtful. With higher interest rates consumers may curb spending, but OPEC has said it may raise oil prices without regard to economic conditions. The cartel likes the extra money too much. Commodity costs are also likely to stay high. In a global economy demand from countries like China, were the costs of oil and some agricultural products are underwritten by the central government, becomes perverse and misshapened.
The Fed has to make a bet now. No bet could lead to stagflation. The wrong bet will be painful but it leads to addressing one problem and not two. Lowering rates saves the economy. Raising rates may not cut the price of most critical goods at all.
Douglas A. McIntyre