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Well, we sure dodged a bullet there, didn’t we?  Oil dropped $17 a barrel in a week, and now everything is gonna be great!  Before you know it, gas will be back to $2.75, closed factories will be re-opening, and our homes will again be worth what they were two years ago.  Party on, Garth!

Wrong.  This party’s not over–it hasn’t even started yet.  The misperception is all about lags.

Much of the damage that has taken place in our economy–the result of surging oil prices and a bursting housing bubble–has occurred this year.   A blink of the eye, in economic terms, and the economy is just now beginning to react.  So far this year, most U.S. businesses have experienced higher energy and fuel costs and have mostly absorbed them.  Those that have delivery charges have raised them, without raising other prices.  However, most businesses haven’t done this, have seen their margins shrinking, and will be “adjusting” in the months to come.  What does this mean going forward?

We’ve seen dramatic recent increases in the PPI and CPI, while the “core” rates have remained rather subdued.  This will be changing later this year, as businesses find themselves no longer able to make ends meet with skinny margins.  They will have two choices–either raise prices, or begin laying people off.

For the huge number of companies that are sole proprietorships, or who employ one or two people, layoffs are impossible.  (If I’m self-employed, I’m not going to lay myself off, although I’ve been considering it.)  Other than going out of business, which a number are doing, raising prices is my only choice.  Companies with employees have already started cutting back, and can be expected to continue doing so, as higher oil prices start showing up in most of their “inputs”–materials, utilities and transportation costs.  With no real pricing leverage, watch for unemployment figures to begin creeping up, along with core inflation rates.

All of the ingredients for a significant recession are now in place, waiting for the Fed to remove its head from the sand and begin raising rates.  Add inflation, and you have stagflation.  And let’s not forget that the government’s economic indices systematically understate both inflation and unemployment; if they say things are okay, they’re bad.  If they say they’re bad, they’re really bad.

There is one big unknown lurking out there.  It’s the combination of inflationary pressures (caused by high energy, food and commodity prices) and deflationary pressures (caused by rising unemployment and the collapse of housing prices).  Reminds me of Steven Wright, the existential comic, who once claimed he was going to “put my humidifier and my dehumidifier in the same room, turn them on, close the door, and let them fight it out.” We shall see where this settles out but, regardless of which side wins, it’s not going to be pretty.

Disclosure: None

Source: Inflation + Recession = Stagflation