Stagflation worries in the present

Stagflation worries in the present During 2006, certain economists believed that global stagflation might return when the price of oil was close to $80 a barrel, and the US Federal Reserve was increasing interest rates. Blogs promoting fears of stagflation began getting attention even before statements by Stephen Roach and Paul Krugman. They cite a cooling housing market combined with a failure to adjust monetary policy as potentially leading to higher than "comfort zone" inflation and slower growth. The worries multiplied in 2007 . On February 28th China's reaction to its complex domestic policy binds triggered a shock to financial markets (DJIA down 5%)as well as a reminder of the danger China had raised in February 2005 when Chinese economist Fan Gang, director of the state-owned National Economic Research Institute in Beijing, recommended publicly [World Economic Forum, January, 2005] that China sell its hoard of U.S. Treasury debt into the world market because interest rates were too low. China is the second-largest holder of U.S. Treasury debt in the world (after Japan). Such an action would send U.S. interest rates soaring, according to most generally-accepted models of the global economy, since such a massive sale would immediately drive down bond values, thereby raising not only the effective interest rate on existing bonds but also the market into which new bonds were sold. These models show that U.S. interest rates would soar. The polico-economic indication from these models was that the U.S. Federal Reserve was already in the policy bind that would contribute to Stagflation. Two days earlier (2-26-2007) U.S. Federal Reserve Chairman Alan Greenspan predicted a possible recession in the U.S. before the year 2007 was over, speaking via satellite link to a Hong Kong business group. Some took this to be an indication that his model also recognized that China's policy binds had created a U.S. policy bind which prevented anti-recessionary action by the U.S. Federal Reserve. Others postulated that the higher interest rates prevailing in the U.S. in 2007 were known by him to be the U.S. response that was implemented to forestall the possibility of China's massive bond sale. Still others voiced the conclusion reached after the Nixon-era price controls that high interest rates were in and of themselves inflationary, since the cost of money was factored into models for the unit cost of everything from the price of wheat to the cost of making a high-budget film in Hollywood, a microeconomic measure prevailing in some modern economic models. At its May 2007 meeting the U.S. Federal Reserve (FOMC Minutes, May 9, 2007, U.S. Treasury Dept.) made the following policy statement: "In these circumstances, the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected. Future policy adjustments will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information." The across-the-board reaction was that the widely anticipated July 2007 lowering of U.S. interest rates was no longer feasible, and the Fed's response confirmed to many who maintain a polico-economic models that U.S. economic policy was unfolding in a manner that confirmed that the policy bind which accompanies Stagflation was becoming more visibly present. On May 11th former U.S. Federal Reserve Chairman Alan Greenspan redefined the odds on a U.S. recession during 2007 from "possible" to "1-in-3". May ended with the widely publicized report that foreign holdings of U. S. Treasury debt maturing in the three-to-ten year range had reached the 80% level, sparking comparisons to 19th Century America when European lenders provided financing for building U.S. infrastructure projects such as railroads and canals. Today's worries leave U.S. domestic economic policy hostage to international economic factors flowing from spiraling U.S. trade deficits and government deficits. The first two weeks of June 2007 brought reports that China's trade surplus for the previous month had exceeded $22 billion, which moved the United States Congress, the OECD and the IMF to forcefully describe China's trade and exchange rate policies as "unfair". Also in June China began to show a reluctance to increase its hoard of U.S. Treasury debt and is thought to be the Asian seller with daily offerings of 10-year Treasury notes in the overnight market. This action drove down values and thereby increased the interest yield from its long-established rate below 5.0% to the 5.1-5.2% range with peaks at 5.3%. One result is that the U.S. housing market went into the biggest slump in 15 years. Furthermore, this higher prevailing interest rate triggered a mini-collapse in the already sagging subprime home mortgage market, which leaves a number of New York investment houses in peril of defamation and legal liabilities. Despite all these adverse signals and an oil price approaching $70 per barrel, the insatiable demand of the U.S. consumer created sufficient optimism for investors to trigger the stock market to its largest three-day advance in 18 months on the occasion of the June 15th triple witching Friday. Ergo, markets were happy. Ultimately, the current worry reaches epic proportions -- the prospect of global stagflation, a phenomena never before encountered.