The word on the Street is stagflation

By John Waggoner,

Gold closed above $900 Monday for the first time, raising fears of "stagflation" — a period of both stagnant economic growth and surging inflation that Americans haven't suffered since the 1970s.

"There's no doubt that 'stagflation' is starting to be used in ways I haven't seen in 30 years or so," says George Milling-Stanley of the World Gold Council.

The price of an ounce of gold rose $5.50 Monday, closing at a record $901.60 on the New York Mercantile Exchange. Gold has soared $66.70 an ounce, or 8%, already this year — and 249% from its monthly low of $258 an ounce in March 2001.

A jump in gold prices is good news, of course, for precious-metals investors. But for the broader economy, rising gold prices are an ominous sign. "Gold prices often signal a rise in people's perception of the potential for future inflation," Milling-Stanley says.

Normally, a slowing economy helps quell inflation, which typically results from an overheated economy that fuels higher wages and prices.

But oil and food prices have remained stubbornly high, even as evidence of a potential recession — a tumbling housing market, sluggish consumer spending, job losses in manufacturing and retailing — is mounting. A barrel of light, sweet crude, for example, closed at $94.20 Monday, nearly double the close of $52.99 a barrel on Jan. 12, 2007.

The falling value of the dollar, too, is an inflationary force. When the dollar falls, the cost of imports rises. On Monday, 1 euro was worth $1.488.

"I think we'll see a test of $1.50 vs. the euro," says Ron Simpson, strategist for Action Economics.

The worst-case scenario: stagflation, a period of slow economic growth and accelerating price increases. "It's a currency killer," Simpson says.

Stagflation would also pose a dilemma for the Federal Reserve. If the Fed lowered interest rates to stimulate the economy, it would run the risk of driving the dollar down even further. Investors boost the currencies of strong economies with the highest interest rates. Yet if the Fed raised rates to squash inflation, the economy could fall into a tailspin.

John Lonski, chief economist for Moody's Investors Service, says he doesn't think the risk of inflation is high enough to stop the Fed from cutting rates. He thinks that when the government reports the December consumer price index this week, inflation will be lower than the 4.3% annual rate recorded for the 12 months that ended in November.

And, he says, labor costs are the biggest factor in an inflationary spiral. "The cost of labor matters more to business than commodity prices," Lonski says.

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