U.S. Federal Reserve Chairman Ben S. Bernanke didn’t use the "S" word - stagflation - but he might as well have.

On Friday, the U.S. central bank chief said that the financial crisis that has hammered the U.S. market is combining with rising inflation to eviscerate American economy. Together, the two forces are making it extremely difficult for the Fed to restore economic stability in the U.S. market.

Bernanke apparently welcomed the recent drop-off in the prices of oil and other key commodities - and says that inflationary pressures will moderate over the next year and a half, but also cautioned that the current inflation outlook remains highly uncertain.

The upshot: The Fed will monitor the economic situation closely and will "act as necessary" to make sure that inflation doesn’t get out of hand.
These dueling cross-currents - a sputtering economy and racing prices - is stagflation, the potentially ruinous manifestation that was once thought to be a theory only, meaning it couldn’t possibly show up in real life. That changed in the 1970s, when soaring energy costs and a collapsing U.S. global competitiveness combined to send the American economy into a tailspin. When the inflation rate peaked at 13.5% in 1981, then-Fed Chairman Paul A. Volcker had to put short-term interest rates up to more than 20% to finally break inflation’s back.

Let’s hope that’s not happening again.

With the afore-mentioned crosscurrents, most economists believe that Fed policymakers will leave short-term rates unchanged when they next meet Sept. 16 - if not for the rest of the year.

Unfortunately, the latest wholesale prices report is a cause for concern, and certainly didn’t put a stop to the recent inflationary fears. In July, the Producer Price Index (PPI) skyrocketed at its fastest rate in nearly 30 years, far exceeding most economists’ forecasts.  While some are keeping a "wait-until-next-month" attitude (when the lower energy prices will be reflected in the numbers), others point to the core data (which excludes the volatile food-and-energy component) as proof that inflation is here to stay - regardless of the shift in energy prices.  Core wholesale prices suffered the largest monthly increase since November 2006 as other sectors clearly have been impacted by the rise in commodities.

At week’s end, however, Bernanke seemed to be reveal that he is most concerned about the sluggish economy; he made his case for the current level of Fed Funds rate of 2.00% by projecting that inflationary "pressures should ease in the coming months as commodity prices fall and the economy slows."

Despite the recent reprieve from record energy prices (and Bernanke’s comments notwithstanding), inflation definitely should remain high on the Fed’s radar screen (and Americans will still feel the pinch in their pocketbooks).  While some analysts expect food and energy prices to lead to lower overall inflation gauges (Consumer Price Index, PPI) in the months to come, the recent core numbers reveal that businesses and consumers will continue to be impacted by price pressures.

The upcoming release of the minutes from last month’s Fed policymaking (Federal Open Market Committee, or FOMC) meeting will delve a bit into the mindset of the policymakers as they continue to face the dual economic threats of sluggish economy vs. inflation.  On that note, the revised second quarter gross domestic product (GDP) estimate will be released and investors are hoping for an upward revision from the 1.9% reported in July.

Most experts had been counting on those tax rebates contributing more to the domestic economic growth.  Confidence and personal income/spending data will help dictate just how active the consumer will be in the months to come.  Retailers (discounter and luxury stores alike) will surely be watching to learn whether they can expect any positive news in time for the holidays.  Finally, two one-time industry leaders, Dell Inc. (DELL) and Sears Holdings Corp. (SHLD), report earnings, though such announcements do not carry the luster they once did.

Market Matters

The latest business headlines are coming to us straight from China - the land that exports much of the world’s toys and other manufactured products and imports significant oil, natural gas and other commodities (greatly contributing to the prior surges in commodities-related prices). With Michael Phelps becoming an overnight hero at the Beijing Summer Olympics, a new corporate bidding war may soon begin as the record medalist prepares to be transformed into the next global marketing sensation (Whatever happened to just being featured on the cover of a Wheaties cereal box - you know, "the breakfast of champions?").

Phelps currently maintains a contract with swimwear company, Speedo [The Warnaco Group Inc. (WRC)], and will collect a cool $1 million bonus for his gold medal accomplishments.  Enter Nike Inc. (NIKE), the sports apparel giant, with a limited swimwear presence.  Analysts project that Phelps could mean $50 million and a huge new market for Nike; the company may come calling with a blank check (Can you say Tiger Woods?  Michael Jordan?).

But here’s the issue as these companies prepare their bids and potentially increase their ad budgets during a period of economic uncertainty.  While Tiger and "MJ" participate(d) in sports that graced TV screens constantly, Phelps will drift into virtual athletic oblivion until London 2012.  Good luck, Michael.  Thanks for making us forget the global financial crisis - even if only for a couple of short days.

Speaking of the global financial crisis… just when it seemed that investors once again found it safe to hold Freddie Mac (FRE) and Fannie Mae (FNM) securities, a negative Barron’s article spooked shareholders that their stock prices were heading to zero amid an imminent government bailout.  Other analysts believed that full-fledged nationalization of the two government sponsored enterprises remains unlikely, and said that major loans from the U.S. Federal Reserve would seem the more logical path should capital infusions be needed.

Meanwhile, the respective stocks plunged to 18-year lows.  On the "lighter" side of the financial news, Goldman Sachs Group Inc. (GS), Merrill Lynch & Co. Inc. (MER), and Deutsche Bank AG (DB) joined UBS AG (UBS), Citigroup Inc. (C), JPMorgan Chase & Co. (JPM), and Morgan Stanley (MS) in reaching settlements with New York Attorney General Andrew Cuomo (doing his best pre-scandal Elliot Spitzer imitation) over past sales of risky securities.  On an even more positive note, analysts at JPMorgan stated that the next two years would be more favorable for financial firms than for energy companies  (Anyone interested in a Lehman Brothers Holdings Inc. (LEH) hostile takeover?).  In earnings news, retailers Home Depot Inc. (HD), Target Corp. (TGT), Saks Inc. (SKS), and Staples Inc. (SPLS) each posted worse-than-expected quarters, revealing that consumers are steering clear of just about every type of store these days.  Techs, however, got a boost as Hewlett-Packard Co. (HPQ) reported surprisingly strong results.   

As the week began, the Dow Jones Industrial Average plummeted more than 300 points in two days as the Freddie/Fannie scare resurfaced.  Fortunately, the eternal optimists pointed to the light volume, which often results in exaggerated price moves (either up or down).  With the summer winding down, traders and investors alike head to the Hamptons for some much-deserved R&R (at least, those who can still afford it).  Oil prices suffered through some excess volatility as traders (over)analyzed the growing tensions between Russia and the United States, the weekly inventory data, and threats of storms in the Gulf that could have disrupted production.  By week’s end, the major equity indexes had bounced back, but still ended in negative territory.  Maybe a few more Olympic successes can put the fear and uncertainty on the backburner again.  (Certainly not the 4 X 100 meter relays).

Economically Speaking

As inflation worries continue to escalate, housing continues to struggle, as July construction starts plunged to their lowest pace since March 1991 and new mortgage applications also declined to levels not seen in almost eight years.  On the bright side (if any really exists), residential sales in So-Cal (Southern California) climbed to a 16-month high as homebuyers and real estate investors (more likely, speculators) finally found some value in certain foreclosed properties.  The predictive index, leading economic indictors, fell far more than expected as the continued slump in building permits led the ongoing pessimism about future housing activity.

Well, at least, So-Cal may be on the mend?  Any other regions care to follow?

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