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High Possibility of Stagflation?

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I have been taking a long break and recharging my batteries. At the same time, I have been busy at work and so when I reach home, most of the time, my energy level is spent. The news on the financial and economy fronts are pretty depressing so far. It is going to be a recession year in 2008 from all the signs and indicators.

The key for the world economy has always been United States. They are the driver because they have the largest consumer market in the world where the people there are big spenders and this spending has been fuelled by the housing boom in the past few years where housing prices have gone up. Mortgages and re-mortgages taken out on houses have enabled the American consumer to spend and spend. When the housing market bottom out last year, a lot of these same consumers got their fingers burnt.

We are seeing the effects of this spreading through the financial system and it will hit the economy very soon. If it hasn't already hit. The alarm bells is when the default rates for the American Express customers went up. This shows that the consumers have their credit drying up and are defaulting on their credit card payment. The cause of that is, of course, the housing market slump. When the house owner money channeled or all tied up to the house, their disposable income falls. And as any half baked economist will tell you, when disposable income fall, this will lead to a fall in the demand for goods and services.

On its own, this is enough to cause a recession, where the economy of US goes into negative. However, what is alarming is that inflation has not halted, and in fact it is showing signs of increasing. This is cause by the high oil prices on one hand and also by the expectation that the Federal Reserve is going to decrease interest rates to prevent United States from going into a deep recession. This expectation of a decrease in interest rates is causing people to sell the US dollars and look for other alternatives like the Euro, gold and other commodities. So it means that the same US dollar will be able to buy decreasing amounts of commodities and oil and so the prices of things goes up everything else being equal.

Some commentators have argued that the chairman of the Federal Reserve should have been more aggressive in cutting interest rates and softening the fall of the US economy. But to that will be to increase the risk of inflation in the US economy and when combined with the impending recession will cause the nightmare of every central banker- stagflation. This is a scenario of stagnation or recession combined with inflation.

It is hard to overcome stagflation because with a recession, prices are high so when interest rates are cut to stimulate lending and growth in the economy, the prices of goods and services goes up. This makes it a disincentive for businesses to expand because when they borrow money it is in a situation where raw material costs may increase to the point it becomes unprofitable for them to produce or provide any goods or services.

Also with increasing prices, demand falls so it doesn't make sense to expand your business and it becomes a huge vicious cycle. So cutting interest rates could be a bad thing to do quickly and continously. The Federal Reserve Chair is being prudent if what I remember of expected inflation which wikipedia explains pretty well from what I remember.

In short what it means is that if everyone expects you to cut interest rates, they will adapt accordingly and act so that when the interest rates is actually cut, businesses will 'counteract the expansionary effect of the increased money supply' and limit its effects.

So in all the Fed Reserve chair is doing everything right in keeping everyone guessing whether he will cut interest rates and by how much. This will help combat inflation. My guess is that he would at most cut interest rates by at most another 0.5% in total this year. He wouldn't want to have another repeat of a low interest rates fuelled housing boom again. However, the risk of a mild stagflation is very high at the moment. So that is why savvy investors are moving to commodities and gold. Gold prices are hitting all time highs.

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