The US economy is facing what financial experts call ‘stagflation.’ Stagflation is a combination in which consumer prices rise faster than is desired, while the economy slows at the same time. Stagflation is a double edged sword and it is definitely not desirable.

With an economy that nearly stalled in the fourth quarter, some are predicting flat, and even a potentially shrinking economy for the first quarter of 2008. Consumer price index readings have been above the desired level for several months. Today (February 26), Wall Street saw an even more disconcerting 7.4% growth report in wholesale prices during 2007. This was the highest annual rise in prices since 1981.

The biggest challenge with stagflation is that the two competing problems can actually restrict the repair of one other. The Fed has been working diligently with interest cuts to help spark the economy into motion. The interest rate cuts are supposed to help encourage business expansion through cheaper credit, while also making it less expensive for consumers to borrow and spend. Without the need to support the economy, the Fed would likely be considering raising ruts to combat the growing inflation.

Fixing the economy is job one for the Fed for now, as inflation is on the back burner. Unfortunately, inflation can actually block some of the developments hoped for with rate cuts. As consumer prices rise, Americans are more protective of their spending and more concerned for their budgets. Falling consumer confidence is an indication that Americans are in a cautious state of mind in the current market.

As consumers are more mindful of spending, businesses see less growth (or losses) in sales and profits. Unable to control the cost of rising prices and needing to maintain profit margins, business often reduce hiring and investment in growth and expansion, to deal with the shrinking consumer demand. This business contraction is opposite the effective designed by rate cuts. This is why economists say stagflation is a very difficult economic dilemma to resolve.

The potential for stagflation is likely a matter of timing. Many economists are hopeful of a second quarter economic turnaround, sparked by the rate cuts and the stimulus package sending tax rebates to consumers in May and June. If the economy can improve before rising prices get out of control, inflation becomes a much easier problem to deal with on its own.

Of worry, though, are several staggering numbers indicating the growing price problem. Along with rising wholesale prices, consumers paid 4.1% more during 2007, than they did during 2006, the largest rise in 17 years. A new oil price record over $100 recently, as well as gold over $900, and several currency records set against the dollar, have also impacted consumers. Gasoline prices are expected to reach new heights. Several food items are at several year highs as well.

Adjusting wages with inflation tied to consumer prices, weekly worker earnings were down 1.4% from a year ago. This means that workers are not seeing wages adjusting fast enough to keep up with the rising prices. The fast fall of the dollar and rising inflation make it difficult for employers to boost earnings soon enough to help employees keep up. This makes it even tougher for Americans to afford products and services.

The Euro reached another new record today, with one Euro worth more than $1.50 for the first time ever in afternoon trade in New York. This was just the latest in a long line of currencies setting all time or multi-year highs against the dollar. While Americans struggle with inflation, foreigners continue to benefit from the weaker dollar in exchanges. Ultimately, the global economy needs to see a stronger US economy, more manageable consumer prices, and especially a stable dollar. Many countries rely on the dollar as a safeguard for their reserves.

Market Recap

Equities had a great day on Monday with stocks bouncing around in extremely volatile trading. The Dow finished up 189 points, just off the highs of the day. The NASDAQ and S&P were up 24 and 18. S&P affirmed the credit rating of Ambac and MBIA giving hope that bond insurers would avoid the credit crunch. Existing home sales and home prices declined again bringing more concern to the housing markets. Tuesday was a great follow up for stocks as the Dow gained another 114, to close at 12,684. Stagflation worries are moving through markets as prices are pushing higher in spite of the sluggish economy. Additional reports seem to indicate a continued grim outlook for the market. Consumer confidence has dropped on job concerns.

Neil Kokemuller
Tuesday, February 26, 2008
7:50 PM EST

Neil Kokemuller is an Associate Professor of Marketing at Des Moines Area Community College in Des Moines, Iowa, USA. He has a MBA from Iowa State University with a specialization in marketing.

Please note: The information provided in this article is intended for informational and entertainment purposes, and not as advice for financial decisions or investments. Actions taken on the basis of the information shared is at the sole risk and discretion of the individual. Currency investment poses significant risk of loss.