Fed worries that inflation will become stagflation

Stocks tanked on Friday and came all the way back on Monday, as investors decided that the Federal Reserve really didn’t mean that it was planning to tighten.

The market’s confusion is matched by the Fed and other central banks, which really don’t know what they should do. On Friday, as we reported, the hawkish tone set by St Louis Federal Reserve Bank chief James Bullard spooked the market.

On Monday, by contrast, former Swiss National Bank president Philipp Hildebrand said that the central banks simply will declare that higher inflation is what they wanted all along. There was too little inflation before, so a bit too much inflation now is just the ticket.

“My guess is we will see a trend saying we have undershot inflation for many years. Now we are accepting some overshooting to make up for that over time. The question will become how much overshooting and for how long,” said the former Swiss central bank chief, who is now vice chairman of the mega-money-manager Blackrock.

Hildebrand’s scenario surely is the one preferred by the Fed. Kicking the can down the road is the least bad alternative in the face of a projected Treasury borrowing requirement of $2.3 trillion. Any move to tighten monetary conditions could send interest rates soaring and stocks crashing, and bring on a recession.

The problem, though, is that inflation itself can choke off economic activity: $5 trillion of federal fiscal stimulus could disappear into savings accounts if consumers push back against higher prices. Americans still are saving about 15% of personal income, double the twenty-year average.

With home prices up nearly 14% year-on-year and rising at a 21% annual rate as of March, Americans think it’s a terrible time to buy a home. And with used car prices up 20% this year alone and 36% year-on-year, they think it’s a terrible time to buy cars, too – along with all major household durables.

We know this from the University of Michigan consumer confidence survey, shown above in the Chart of the Day.

Blackrock’s Hildebrand no doubt is right about what the Fed would like to do. But it may not get to do it. As we reported June 19, the gap between prices paid by US manufacturers and prices received is close to its all-time widest. Every time that happened in the past the US economy went into recession.

The University of Michigan data are worrying. The Fed can’t keep the can of beans on the burner forever. Eventually it will be scraping beans off the ceiling. The economy could already be in a downturn, or it could struggle on for many months. We’ve seen this movie before; we just don’t know how long the remake will require to get to the same ending.