Inflation or Slowing Growth: The Fed Can't Win

The Fed is caught in a bind. With the S&P/Case-Shiller Index reporting another drop of 15.3 percent from May a year earlier, and with the Conference Board's confidence index reported down to 50.4 in June from May's 58.1, combating rising inflation with an increase in interest rates is politically impossible. Nevertheless, defending the dollar and addressing biting price increases by raising interest rates will offer the macro economy a firm signal of the Fed's resolve to quickly end our current bout of inflation.

Today, a confluence of extraordinary economic events, both domestic and globally, are truly unprecedented in our lifetime. Europe and the rest of the world have other ideas. Disagreement between France and other EU members, notwithstanding, central banks around the world are raising rates even in the eye of economic deceleration. The Group of Eight will be meeting July 7th thru July 9th, at the Hokkaido Toyako Summit in Japan. They will address the issues of rising oil prices and stabilization of financial markets.

The next FOMC meeting takes place on August 5th. It is inconceivable that the US will escape the oncoming recession. Disposable income for consumers is at the lowest point it's been this decade. Financial institutions are deleveraging their balance sheets, tightening lending requirements, and are facing new, tougher capital requirements by regulators. Unemployment is rising. Income, adjusted for inflation during the latest expansion, actually fell.

Once upon a time, real estate appreciation allowed workers some relief from stagnant wages. Home equity loans, which provided working capital to families to enjoy elective pleasures, are all but gone. Without this powerful income stream, domestic growth must lag. Soaring gas prices at the pump and higher food costs are stinging shoppers and changing buying habits.

On June 20th, the Mortgage Bankers Association reported single-family housing starts dropped 1.0 percent in May, the lowest level they've been at since 1991. Also, single-family permits fell 4.0 percent, offsetting April's gain of 4.5 percent; this was permits first gain in 13 months. On June 5th, MBA reported the national rate of foreclosures and the rate of loans in the process of foreclosure is the highest since 1979.

According to the Energy Information Administration [EIA], in 1990, the cost of US Regular Conventional Retail Gasoline per gallon was $1.192 and by 2001, $1.456, a 22.15 percent increase over 10 years. From 2001 to last week, the cost of motor gasoline rose to $4.002, a 174.86 percent increase. The result: there has been a 31,127 barrel-a-day decline in purchases, between October 2007 and March 2008.

Servicing debt is becoming harder and harder to do, as those in debt must do so managing reduced cash flow. The collapse of the dollar, surging energy prices, global economic change and uncertainty, and higher production costs mirror the 1970s. Whether we exit this recession to confront just stagflation, or something different (and possibly worse) depends on which battle the Fed acts on. Either way, the Fed can't win.