Is Stagflation Making a Comeback?

Hey, guess which relic from the 1970s is back. No, it's not polyester leisure wear. And it's not soft rock. It's stagflation.

With the economy widely expected to slow dramatically in 2008 and inflation numbers worse than they've been in more than two decades, we could very well experience a time warp back to the days of disco, when spiraling inflation joined forces with economic stagnation -- slow to no growth, combined with rising unemployment -- to create the portmanteau word economists still use today.

Let's order some "Whip Inflation Now" buttons
Last week, the Labor Department reported inflation numbers that were positively startling. Driven by a 14.1% spike in energy costs and an astounding 34.8% jump in food costs, wholesale prices rose 3.2% in November, the largest monthly gain since August 1973 and far beyond what analysts expected. Meanwhile, producer prices rose 7.2% -- the largest increase since 1981 -- and core producer prices, which exclude food and energy, rose 0.4% in November, twice the consensus forecast. After a cold slap in the face like this, economists are expecting higher inflation than we've seen in a long time for 2008.

The growth picture is just as bleak. Most economists are predicting anemic growth for 2008, and some are even predicting a recession, now that consumers have been weakened from the housing bubble and the credit crunch that resulted from the subprime-loan crisis.

According to Peter Morici, a former chief economist at the U.S. International Trade Commission: "Slow jobs growth, along with the shortage of business credit, declining home prices, and falling industrial production, indicate the risk of a recession is clearly above 50%. Either the economy has already entered a recession, or the risk that a recession will begin soon exceeds 50%."

Even Alan Greenspan, the former Federal Reserve chairman, acknowledged this weekend that because of the combination of slower growth and soaring energy prices, the economy is showing early signs of stagflation. He also believes there is a 50% chance of recession in 2008. Other economists aren't quite so pessimistic, but the overwhelming consensus is indeed negative for 2008.

The pain of stagflation could be considerable. Stagflation is absolutely awful for the stock market. Meanwhile, the job market and the overall economic environment could languish while the cost of living continues to rise. And making less money while paying more to live is not an enviable situation.

Whither the Fed?
This situation puts the Federal Reserve in a tricky spot. On one hand, the Fed wants to lower interest rates to increase liquidity and combat the economic slowdown, but lowering rates tends to be inflationary and conflicts with the Fed's ability to fight inflation. What to do? Central banks have concocted a plan to pump liquidity into the system by offering short-term loans at highly favorable rates to member banks and, if all goes as planned, help alleviate the effects of the credit crunch. While this move is generally perceived as a step in the right direction, market reaction has been, shall we say, unenthusiastic. And the market doesn't lie.

Not all of the news has been bad. Retail sales figures have been stronger than expected for the Christmas season so far. As of now, it looks as though this will turn out to be at least a decent season for retailers. What's more, the best remedy for inflation is slow growth. In fact, slower growth may, in and of itself, fend off inflation and stagflation.

This Fool believes that we will not experience stagflation. However, I will add a word of caution: Should something else go wrong -- be it a terrorist attack, a natural disaster, geopolitical disturbances, or anything else along those lines -- we could very well experience stagflation, or a recession, or both.

For investors, the likely market volatility to come could create a historic opportunity to buy high-quality stocks at low prices. Specifically, financial-services stocks should be cheaper on a relative basis than they've been in decades. Stocks such as Bank of America (NYSE: BAC  ) , Merrill Lynch (NYSE: MER  ) , US Bancorp (NYSE: USB  ) , and JPMorgan Chase (NYSE: JPM  ) could all end up at fire-sale prices within the next few months. As Warren Buffett says, "Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."

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