Inflation May Cause Economic Double Dip

The worst possible outcome may be a W-shaped recession, which business professor Nouriel Roubini predicts is a serious risk if inflation is not controlled by an effective monetary …

The worst possible outcome may be a W-shaped recession, which business professor Nouriel Roubini predicts is a serious risk if inflation is not controlled by an effective monetary exit strategy. However, the Fed faces a two front battle between controlling inflation and not undermining the recovery. Money Morning discusses the delicate balance the Fed must achieve in order to pull the economy through this uncertain time.

Nouriel Roubini, professor at the Stern Business School at New York University said in an op-ed piece in Monday’s edition of the Financial Times that while the global economy is “starting to bottom out” there is “a rising risk of a double-dip W-shaped recession,” mainly because of the threat posed by inflation.

According to Roubini, who is often credited with predicting the financial meltdown, there are three open questions concerning the global economy:

  • When will the recession be over?
  • What will be the shape of the economic recovery?
  • Are there risks of a relapse?

The first question is different for every country, as some had more exposure to the U.S. housing collapse than others. While the U.S. economy – and the economies of the United Kingdom and Spain – continues to languish, recoveries are already underway in emerging markets such as China and Brazil.

China’s economy grew by 7.9% in the second quarter, exceeding most analysts’ expectations, and lending credence to Beijing’s goal of 8% annual growth. Meanwhile, Brazil’s economy expanded at an annual rate of 6% in the second quarter.

Even those recoveries could wear thin if domestic demand remains weak, Roubini said, but the situation is far more severe in developed economies, where central banks will have to make some very difficult decisions regarding “exit strategies.”

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U.S. Federal Reserve Chairman Ben S. Bernanke in July outlined his plan for a “smooth and timely” withdrawal of monetary stimulus from the U.S. economy.

Bernanke pointed out some of the Fed’s emergency lending facilities automatically wind down as the economy recovers, because they have onerous pricing and terms. But two key measures could be taken to accelerate the process:

  • Increase the amount of interest paid on balances held at the Federal Reserve by depository institutions (banks).
  • Selling securities from the Federal Reserve’s portfolio with the agreement to buy them back at a later date.

However, Bernanke did not give any clues about when the strategy would be implemented. That is, at what point will inflation become enough of a concern, and at what point does U.S. growth become sustainable enough, to warrant a change in Fed policy?

In this sense, “policymakers are damned if they do and damned if they don’t,” said Roubini.

“If they take large fiscal deficits seriously and raise taxes, cut spending and mop up excess liquidity soon, they would undermine recovery and tip the economy back into stag-deflation (recession and deflation),” he said. “But if they maintain large budget deficits, bond market vigilantes will punish policymakers. Then, inflationary expectations will increase, long-term government bond yields would rise and borrowing rates will go up sharply, leading to stagflation.”

Earlier this month, Bernanke said that the benchmark Federal Funds rate, which currently stands at a record-low range of 0-0.25%, would remain “exceptionally low” for “an extended period” of time. Similarly, European policymakers, who are traditionally more hawkish, said over the weekend that there is still no reason to start reining in stimulus.

“There is no reason to reassess our monetary-policy stance,” Erkki Liikanen, Finland’s central bank governor and a member of the European Central Bank’s (ECB) governing council told Bloomberg News.

Meanwhile, commodities prices are picking up momentum as the global economy edges toward recovery. Oil prices yesterday approached $75 a barrel for the first time in 10 months. Benchmark crude for October delivery rose 31 cents to $74.20 a barrel on the New York Mercantile Exchange.

“Oil, energy and food prices are now rising faster than economic fundamentals warrant, and could be driven higher by excessive liquidity chasing assets and by speculative demand,” Roubini said, noting that oil at $147 a barrel was the tipping point for the global economy last year. “The global economy could not withstand another contractionary shock if similar speculation drives oil rapidly towards $100 a barrel.”

Roubini also cited rising unemployment, low consumer confidence, and falling home prices as factors that will keep the U.S. economy from staging a quick recovery.

This article has been republished from Money Morning. You can also view this article at
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