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Farrell: Semi Stagflation?

Soleil Securities and Ticonderoga Securities are getting married. Ticonderoga is buying Soleil and we are soon going to be a bigger, happier family with a very broad and powerful research product. That's the advertisement; it's over. With any new venture there ought to be some revamping of procedures to achieve 'best in practice' methods.

So far I have been ignored with my plea to start the morning research meeting other than what feels like the middle of the night. They say as you get older you need less sleep. Well, I'm fulfilling the getting older part but I seem to need to same amount of sleep. I confess I use my senior citizen card to work from home a couple of days a week (boy-oh-boy, are my bosses - and there are a lot of them - wonderful, visionary guys).

But when I go to the NYC office, it is a 5 AM wake-up to get to the train. It's my choice to live where I do (well, maybe it's Mrs. Farrell's choice - kidding , honey, kidding) but I will not give up lobbying to start the morning meeting after lunch.

What has this to do with the price of eggs? Probably nothing, but in my mind-fog on Friday a question from our head of sales, Alan Randolph, managed to penetrate. It was direct enough: are we in a stagflation economic environment? It's now later in the day and I have been thinking more about the issue.

First quarter GDP was announced this week as rising at an annual rate of 1.8%. Headline inflation, that is the inflation you and I most feel since it includes the costs for food and energy, is rising at a faster rate than GDP growth, the definition of stagflation; inflation higher than economic growth. Core inflation - inflation without food and energy costs - is rising at a rate less than GDP. So it looks, for the moment, we have stagflation-lite, or a semi-stagflation state of affairs.

We have talked about the reason both measures of inflation are used, and Fed Chair Bernanke prefers the core rate. It seems to many that if you retreat to saying "Well, in the long run.." it's worth remembering that in the long run we are all dead. Ben says higher food and energy costs are "transitory", but the transition can be long enough to break our bank accounts. The market can stay irrational far longer than we can stay solvent.

Economists (those were the smart guys in college who wouldn't talk to the rest of us) say stagflation can occur for two reasons. It can result when a nation is hit with a sudden shock, like high oil prices or the recent financial shock, and the productive capacity/abilities of a nation are reduced, or made more expensive.

Such a shock raises prices (like high gas or a rise in the cost of obtaining credit, if you can obtain it at all), and at the same time makes production more expensive and/or less profitable. So growth slows, but costs rise.

Second, central banks (like our Federal Reserve) can cause inflation by permitting excessive growth in the money supply or the government over-regulates goods and labor markets. Costs go up faster than growth. Keynesian economists ignored the possibility of stagflation because history more or less showed high unemployment was associated with low inflation.

This relationship was called the Phillips curve. The Phillips chart showed money created demand for goods; prices went up; firms hired more; demand then went up more since more people were working.

But in the 1970's and 1980's when we had stagflation it was obvious the relationship between inflation and employment was unstable; the Phillips curve could 'shift'. If you 'expected' more inflation, Milton Friedman argued, workers would demand higher wages and costs, and inflation, would go up. So more inflation could happen at any level of unemployment.

Well we have had two major shocks to the economy, and growth surprised us on the downside in the first quarter. Headline inflation is creeping up. But unemployment is still abnormally high and there is, as yet, no wage pressure. Or at least no wage pressure that can't be ignored.

Wages are 70% of the cost of goods sold in the US and without rising wages it is tough to see stagflation (or inflation as well) taking hold. You want to avoid this stuff because the actions required to lower inflation, harm economic growth. And the actions taken to stimulate economic growth can often create inflation. My guess is that our greater risk is inflation.

The Fed has kept interest rates near zero for over two years. The QE programs have flooded the market with liquidity. Most of QE 1 was deposited back at the Central Bank where it is waiting to roar. QE2 liquidity seems to have found its way into the stock and commodity markets.

There is a thought that the higher FDIC fees have absorbed that liquidity (a topic for another aper) but there is no doubt the Fed has been expansive. To most of us it seems that inflation is everywhere but at the Fed. I doubt oil prices will retreat much. The Middle East needs $90 plus to balance its budgets and, if disciplined (yeah, right) they will get their way. Futures prices on grain and corn are at high levels indicating it will be a while before there can be food price relief.

We find ourselves in a bit of a European type dilemma. Germany wants higher rates to slow inflation, but higher rates will hurt the southern members of the EU. Inflationary indications warrant higher rates in the US but higher rates could damage what Ben seems to think is a still fragile recovery.

But when you have mismanaged your finances to the extent the U.S. has, you have no good choice. Just what is the least bad choice. I think inflation is the cruelest tax of all and, to me, the biggest danger. Ben, Ben, it's your cousin Vinnie from New York (now you know why I go by Vince). Hey Ben, have you filled your car with gas lately? I have a gray SUV. It's either Ford or a Chevy, I can't remember. Nor do I care. But it cost $96 to fill it up and I don't use premium gas.

I more or less share the food shopping in our house. Not too big a deal with the kids grown and gone. But I spent $8 the other day for what seemed to me to be a small box of granola. If the economy were to pick up and demand for money rise, the velocity coming out of that enormous Fed balance sheet will cause inflation to rise rapidly. Can you drain the bathtub that quickly ? Like I said above, this transition is killing us.

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