Stagflation Worries Loom as Inflation Soars and Housing Remains Weak

By Jennifer Yousfi
Managing Editor

Another round of troubling economic data indicates the U.S. Federal Reserve must act wisely in order to avoid a period of stagflation.

Producer prices rose again in May, while housing starts continue to be at a record low. The United States last experienced soaring inflation coupled with a stagnation of the domestic economy, known as stagflation, in the late 70s to early 80s.

The Fed must carefully balance any future monetary policy decisions, as any move to correct inflation could further hamper growth. And the opposite holds true as well, as any moves to boost growth will likely feed inflation.

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"We have very weak housing with no sign yet of a turnaround and meanwhile rising food and energy costs are boosting wholesale inflation," Gary Thayer, senior economist at Wachovia Securities (WB) in St. Louis, told Reuters.

The producer price index (PPI) increased 1.4% in May, the largest jump since November, the Labor Department announced yesterday (Tuesday). Over the last 12 months, producer prices have increased 7.2% compared to the 6.5% increase in April. Core inflation, which excludes volatile food and energy costs, only increased 0.2%. But as any struggling business owner knows, commodity prices are taking a big bite out of the bottom line as oil flirts with $140 a barrel and the cost of raw ingredients continue to climb.

"Just about everywhere prices are rising and they are doing so at a strong pace," Joel Naroff, president and chief economist at Naroff Economic Advisors, wrote in a note to clients yesterday. "While the pathway from intermediate and crude goods price increases to consumer prices is quite unclear, it is never good news to see the extensive nature of price increases that were contained in this report."

In a separate report, the Commerce Department announced yesterday that housing starts declined 3.3% in May to hit a 17-year low of 975,000 on a seasonally adjusted rate. Demand for new homes continues to hall as the increase in foreclosures adds to an already saturated housing inventory.

"The U.S. housing market remains mired deep in recession, with the excess supply problem exacerbated by tightening credit standards," wrote Robert Kavcic, an economist for BMO Capital Markets, who said construction won't recover until prices fall far enough to bring back buyers, MarketWatch reported.

Monday, the National Association of Home Builders reported builders' sentiment is at its lowest level since the survey's inception 22 years ago.

"Housing construction continues to fade making it likely that this sector will once again be a major constraining factor to overall economic growth," Naroff said.

The conflicting reports put the Fed in a precarious position. While many clamor for an increase to the Fed Funds rate to combat soaring inflation and strengthen the weak greenback, all signs point to a U.S. economy that will continue to be soft.

"We will not likely see the next action, rate hikes, until late in this year at the earliest," Naroff said. "The housing and industrial production data released today do not tell us the economy has stabilized to the point where the Fed would have any cover to raise rates."

The Fed's Federal Open Market Committee (FOMC) is scheduled to meet June 24 and 25. It is widely expected that the FOMC will vote to hold rates steady.

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