Light at Tunnel’s End or Eye of the Storm?

We now are caught between the forces of inflation – food and fuel – and deflation – homes and other assets: irresistible force meeting immovable object. The Federal Reserve’s Open Market Committee April meeting minutes released recently gave indication the central bankers indeed now are worried about the effects of inflation, namely higher prices (inflation technically being an economist’s term denoting a period of increasing money supply, as in “too much money chasing a finite quantity of goods”).

But Fed officials also acknowledge they are fighting a difficult, two-front war against slow economic growth and soaring commodity prices – “stagflation” – an economic phenomenon whose last known whereabouts were sometime in the 1970s during the last substantial period of vast amounts of money in hot pursuit of agricultural, mineral and hydrocarbon goods.

Since the early 1970s, dollars have been created at will, not only by the Federal Reserve, which creates money by buying Treasury obligations from banks on the open market (hence Fed “Open Market” Committee) and deposits the proceeds into their accounts at the central bank. In our fraction-reserve banking system, banks then lend out excess reserves. When all is said and done, for every $100 created by the Fed, another $800 or so is created within the banking system.

And since the late 1970s our central bank has had plenty of government bonds from which to choose as a generation of deficit spending has resulted in the issuance of trillions of dollars of new treasury obligations (now exceeding $5.3 trillion of “public” debt).

All this money has been swirling around the world for years, building modern factories in faraway countries where labor costs to staff those factories are a fraction of those in the U.S. or building the world’s tallest buildings in the Middle East and Asia, enabling us to buy inexpensive imported merchandise and, at least until this new decade, inexpensive oil to fuel our American lifestyle.

Now – again - we are seeing the impact of “cost-push” inflation as higher input (raw material/labor) costs drive up finished goods prices, including, for the first time in a while, imported goods as input costs rise in China and other previously low-cost producers.

Money, unlike matter which can neither be created or destroyed Einstein and others postulated, is being destroyed at a copious clip at the margins of the nation, where cratering real estate prices – with no sign yet of stabilization – are translating to all manner of domino-falling – layoffs, retail sales, commercial real estate, state-government budget shortfalls, and so on - as DEflation marches through, as Sherman to the sea, wide swaths of our economy. Irresistible force meets immovable object: the result is stagflation.

Keenly watched money supply numbers bear out this epic struggle as massive increases in credit (money) creation in parts of the economy are being offset by wholesale write-offs, short-sales, liquidations and bankruptcies in other segments.

The worst IS over credit-crunch-wise according to some very knowledgeable people including the Secretary of the Treasury, who, confidently, have pronounced a bottoming of negative economic conditions. But is it “the” bottom?

The worst is NOT over, according to other, presumably equally knowledgeable people, including Warren Buffett, who says “don’t bet against America,” but is buying big chunks of assets outside the country and predicts a “long and deep” U.S. economic downturn.

Clearly a lot of people are “talking their book,” promoting views most beneficial to their own particular, current investment strategy, including many of those appearing on business-cable-TV urging expensive, taxpayer-funded bailout plans of every stripe.

Presidential candidates are proposing federal gasoline tax rollbacks and the House of Representatives, all 435 of whom also campaigning for re-election, has voted to sue OPEC for electing to allow insufficient quantities of petroleum to seep from the earth, preferring, instead, to let its value appreciate in situ (much as bags of flour have gained value in our pantries the last year).

Consumer confidence fell below 60 in May, level not seen since Jimmy Carter wore cardigans in the White House, and, more concernedly, down from the upper 90s only a year ago, even though preliminary First Quarter 2008 GDP was reported as +0.6%.

It’s not a recession, however, until the National Bureau for Economic Research says it is, and it doesn’t pay much attention to GDP.

NBER monitors four factors: employment, real personal income, industrial production and real manufacturing/trade sales. All four factors peaked between September 2007 (personal income) and January 2008 (industrial production). Ultimately, as NBER will soon confirm, the recession likely began sometime in the Fourth Quarter of 2007. It’s called stagflation - but you knew that already.