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To: Return to Sender who wrote (23147)	5/3/2005 7:35:46 AM
From: sixty2nds	Read Replies (1) \| Respond to of 95487

Updated: 02-May-05 08:30 ET The Stagflation Talk is 100% Wrong - the Fed has Control [Briefing.com - Dick Green] Inflation rates are increasing. Economic growth is slowing. That has led some pessimists to resurrect a 1970s word - stagflation. Yet, current conditions are nothing of the sort. In fact, the stagflation talk has the situation completely backwards. Current economic conditions are such that the Federal Reserve will be able re-establish noninflationary growth. This is good news for the stock market. True Stagflation Stagflation is a condition in which inflation not only coexists with a stagnant economy, but is a major factor in curtailing economic growth. Economists of the 1960s and before thought such conditions impossible because it was believed that weak economic growth would reduce price pressures. The 1970s proved the textbooks wrong. In the 1970s an overly timid Federal Reserve failed to act to curtail inflationary pressures that were building over time. Throughout the 1970s, the Fed was consistently behind the curve - inflation would pick up a bit, and then the Fed would raise interest rates a bit. But the Fed never raised interest rates enough to stop the inflationary spiral. In this circumstance, rising inflation rates led to higher interest rates which then curtailed business expansion. High inflation rates led to stagnant economic growth. The economy got stuck in a viscous cycle as higher costs (particularly wages) produced higher prices, which led to higher wage demands, etc. Cost pressures drove inflationary expectations, which in turn drove economic expectations. This Time it is Demand Driven The current situation is the complete opposite. Economic growth boomed in 2004. This eventually led to broad increases in demand that in turn led to modest inflationary pressures. Current inflation is classic demand-based inflation. The Federal Reserve has responded to this increase in inflation by raising interest rates. The ultimate intent is to reduce inflationary pressures, but the manner in which to do so is by reducing demand. And that is exactly what is occurring. It is now clear that economic growth has slowed from the torrid pace of 2004. Last year, real GDP rose 4.4%. The first quarter of 2005 has gotten off to a slower start, with a 3.1% rate of growth. That isn't exactly "weak," as it is equal to the longer-term growth rate for the economy, but it is clearly slower than the pace of the past one an one-half years. Consumer spending and business investment trends are such that it appears that growth will stay at a slower pace. Rather than fearing this slowdown, the Federal Reserve is actually producing the desired results. It is via this slowdown in demand that inflation rates will now come down. Inflation Trends Inflation rates are creeping higher. The year-over-year increase in core CPI is at 2.3% through March. That is up from 1.1% a year ago. It is obviously also not overwhelming. It is not anywhere near the 12% to 15% levels that produced the self-fulfilling prophecy of inflationary expectations such as was the case in the 1970s. In fact, the conditions that have allowed inflation to rise are also vastly different. The strong demand of the past year has finally allowed companies to put through some price increases. Costs are not the major factor. Yes, energy and commodity prices are higher, but they are a surprisingly small factor in business cost structure now. Wages are the vast majority of costs. And there, the pressures are limited. The year-over-year increase in hourly wage rates is only 2.6%. Furthermore, with productivity gains, unit labor costs are up just 1.4% through the fourth quarter of last year. This is not cost-push inflation of the sort that occurred in the 1970s. It is demand-push inflation, and thus can be dealt with in a completely different manner. The Fed's Plan The Federal Reserve is raising interest rates to curtail inflation. They will do this by first reducing demand, which will then lead to a decrease in inflation. Over the next several months, the stabilization in inflation rates will become apparent. It many take a few months, but global competitive pressures are simply too great to allow inflation to continue upward in period of slower growth. Particularly with strong productivity gains that keep wage costs under control for businesses, the ability to increase prices will dissipate. In the 1970s the Fed did not have the ability to smash inflationary expectations without causing a steep recession. That did not occur until the resolute Paul Volcker took over the Fed Chairmanship. This time, inflation rates are 3%, not 15%. Global competitive pressures are much more severe, and productivity gains much higher. It will not take a recession to tame this demand-pull inflation. What it All Means The market right now is faced with the worst of both worlds - economic growth is slowing, while inflation is increasing. The shock value of using the term "stagflation" allows the bears to highlight these negative factors. Yet, the use of the word implies conditions which do not exist, and remedies which are not necessary. The current modest increase in inflation is demand based, and will be corrected with a slowdown in economic growth. It will take some time, but once the market starts looking past the current negatives, it will become apparent that inflation rates will stabilize or decline. It may not be until late summer that the stock market becomes convinced that the Fed has inflation back under control. When that does happen, the outlook for the stock market will brighten considerably, and may well set the stage for a classic fall rally. We expect the Fed to raise interest rates another 1/4% point tomorrow. We are not sure where the Fed believes the long-sought "neutral" level is, but it is within sight. The economy has started to slow to long-term trends, and that by definition means rates are near neutral. In our opinion, the Fed has done a masterful job taking a steady approach to policy. They have allowed inflation to pick up a bit recently, but the process of controlling inflation takes time. The Fed is on track for doing exactly that. By the end of the year, real GDP growth may be tracking near its long-term trend of 3%, and inflation could stabilize near 2%. This can be accomplished without a recession. For anyone that actually experienced the 1970s, this is a far cry from true stagflation. Dick Green, Briefing.com