What’s Next, the Return of Disco Music?

What’s Next, the Return of Disco Music?

“They” always say bad news comes in droves. Well this week was certainly a case in point for economic data as weak reports came in for a variety of indicators ranging from housing to regional manufacturing activity. In addition, the Fed Open Market Committee (FOMC) released the minutes to their most recent monetary policy meeting. The minutes show that the Fed is likely geared to cut interest rates further due to the persistence of downside risks, but also showed members being very concerned that past interest rate reductions may not do the trick in steering the economy away from a recession. With all this in mind, policymakers dropped their projection of 2008 real GDP growth from 2 percent down to 1.3 percent, placing much of the blame on housing, credit conditions and oil prices.

Since the whole federal fund and discount rate reduction process started, inflation has remained a sticky point for the Fed. Indeed, CPI data released yesterday showed the largest year-over-year increase in nearly 16 years. Energy prices are clearly a factor since oil continues to hover around the $100/barrel mark again, but even stripping out energy and food prices, core CPI still shows that inflation is accelerating. Some FOMC members noted the importance of guarding against inflation; however, the general consensus appears tilted more toward ensuring growth prospects begin to improve before inflation becomes concern #1 for the Fed.

Nonetheless, whispers of the word “stagflation” have cropped up in recent weeks, in response to the uptick in inflation and signs of slower economic growth. Stagflation is characterized by both rising inflation and rising unemployment, and is generally agreed to have occurred only in the U.S. during the 1970s following a culmination of bad fiscal and monetary policies, as well as demographic changes. For a brief review of stagflation, see this article (subscription required). While a repeat of the 1970s is long on the odds at this point (please no more bell-bottom flannel pants), any damage to the Fed’s inflation-fighting credentials could make conditions feel eerily similar to those not so good ol’ days.

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