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Is the US economy facing stagflation? (How should the Fed react?)

At first glance, the question may seem misplaced. We have recently known that US GDP grew at an annual rate of 3.9% in the third quarter of the year, whereas inflation rate was 2.8% in September. No stagnation and not too much inflation there. However, plenty of evidence is suggesting that the fourth quarter might look quite different. Growth could be drastically reduced or even be negative, while inflation rates might jump up to 5%. That would very much look like stagflation, one of the most feared events for central banks, since there is no obvious policy response to it.

One reason for anticipating higher inflation is crude oil prices. In just three months the oil barrel has approached $100 a barrel, starting from little above $70. Gasoline prices have not increased much yet, but they could easily rise by around 30% from October to December. This would translate into a rise of close to two percentage points in the annual inflation rate, which would thereby approach 5%. A 4% rate would already be threatening enough.

Stagnation will have more than one source. The most obvious is again the price of gasoline. A 20% to 30% increase in gasoline prices might reduce real consumer spending by 0.6 to 1 percentage points. Of course, starting from the 3% annual rate growth of consumer spending in the third quarter, this shouldn’t be enough to produce stagnation. However, there are other forces in play. The ongoing housing downturn, which reduced third quarter GDP in one percentage point, has likely become even worse, and with the contribution of the credit crisis, is likely to affect consumption. In particular, consumers will be hit by a significant tightening of lending conditions and by price losses in houses and shares. Tougher credit conditions will also affect non-residential investment, which is already signaling deceleration. Finally, foreign trade will be hit by higher energy prices and maybe even by the sharp depreciation of the dollar.

Should the Fed react to inflation, to stagnation or to none of them? I would say growth should remain the driving factor. Not because inflation is not important, but because inflation will probably decline on its own during 2008 and core inflation will stay close to 2% (in September, 2.1%). The former is based on the assumption that global energy demand will moderate and supply will increase (there are OPEP reserves). The later relies on an assumption of slow (under 2% rate) consumer demand growth in the US in the next quarters. Economic growth is the main concern.