Why What Happened on Wall Street This Week Was Important and What's The Concern About Inflation?

As most of us know, commodities prices have rocketed for a quite some time now. Just consider how the price of oil and gold, just to name two commodities, have surged to record high levels in recent history. However, this week, commodity prices dropped drastically. By one account, commodity prices posted the largest decline in in last 50 years. The dollar came back from its lowest level since the early 1970s because of recent actions taken by the Federal Reserve and Treasury.

Based on the actions of late by the Administration,Fed and Treasury, the stock market may be taking a turn for the better and the initiatives by, most notably by the Fed, may already be starting to pay off.

The Federal Reserve has taken a number of measures of late - including lowering the discount and fed funds rates, providing over $400 billion in lending programs, providing a sizeable loan to JP Morgan Chase as it concerned Bear Stearns, providing a new overnight borrowing facility for key lenders, etc. Taken together these moves were bold and already look like they may be effective for stimulating the economy and stabilizing the housing market.

Now, how about inflation? Are the actions taken by the Fed inflationary? The Fed's actions by restoring market liquidity by flooding it with massive amounts of money would seem to suggest that it is inflationary. However, the Fed, while flooding the market with massive amounts of money also sold off Treasury securities. This has the effect of putting a wet blanket on any potentially inflationary actions by the Fed.

Will we see an era, like we did in the 1970s, of stagflation? Stagflation is when the economy is recessed yet inflation rages. Because of the downturn in the economy over the last several months combined with soaring commodities prices, it was looking like stagflation might, in fact, return. Yet, because consumer demand is weak this has the effect of keeping any increase in prices in check. As prices increase, demand will eventually diminish and cause inflationary pressures to subside.

Overall growth in the economy is by far much more inflationary than any increase in commodity prices. Commodity prices are just a small portion of overall production costs. Changes in commodity prices account for a small part of inflation exclusive of the costs of energy and food. Labor costs, which are figured to be about 75% of all costs, represent a far greater inflationary threat. However, we do not have increasing labor costs at this time in the economy.

The housing bubble and now the commodities bubble have burst and the effect is not inflationary. As a matter of fact, it is deflationary. The downward pressure on housing prices certainly is not the stuff that inflation is made of. The credit crunch we are now experiencing is one that could prevent a reviving of the economy.

We now have a situation in which lenders do not want to lend. The danger here is that the Fed is wanting to stimulate the economy while the banks are digging in their heels. This is the situation to watch at this point. It will be interesting to see how this works its way out.