Mainstream economists will be increasingly stating that the real GDP ‘speed limit’ is falling or even negative. That is, the non
inflationary growth potential has dropped, and any attempt to support real growth at higher than that ‘non inflationary natural rate’ will only accelerate an already more than problematic inflation rate.

That puts the Fed in the position of either not accommodating the negative supply shocks of food/crude/imported prices or driving up inflation and making things much worse not too far in the future.

And they all believe that once you let the inflation cat out of the bag – expectations elevate- it’s to late and the long struggle to bring it down begins.

So yes, the economy is weak, but they will be thinking that’s the best it can do as demand is still sufficient to support accelerating inflation.

Bernanke, King Risk Inflation to Extend Growth Party

2008-01-03 04:17 (New York)
By Simon Kennedy
(Bloomberg)

Ben S. Bernanke, Mervyn King and fellow central bankers may go on filling up the world economy’s punch bowl in 2008, even at the risk of an inflationary hangover.

Signs that the party is ending for global growth are keeping monetary policy leaning in the same direction at major central banks, with those in the U.K. and Canada likely to join Bernanke’s Federal Reserve in cutting interest rates again. The same conditions may lead the European Central Bank and the Bank of Japan, which shelved plans for raising rates, to remain on hold for months.

“I expect 2008 to mark the beginning of another global liquidity cycle,” says Joachim Fels, Morgan Stanley’s London-based co-chief economist. “More signs of slowdown or even recession are likely to swing the balance towards more aggressive monetary easing in the advanced economies.”

Going against former Fed Chairman William McChesney Martin’s famous central-banker job description — “to take away the punch bowl just when the party gets going” — isn’t an easy call for Bernanke, Bank of England Governor King and other policy makers. Global inflation is the fastest in a decade, say economists at JPMorgan Chase & Co., and easier money policy may accelerate it further.

“Slowing growth and rising inflation will test central bankers to the full,” in 2008, says Nick Kounis, an economist at Fortis Bank NV in Amsterdam.

Hoarding Cash

After growing since 2003 at the fastest rate in three decades, the world economy is being threatened by a surge in credit costs as banks hoard cash and write off losses tied to investments in U.S. mortgages. The Organization for Economic Cooperation and Development in Paris estimates global growth in 2008 will be the weakest since 2003.

In the U.S., the slowdown may turn into recession this year, say economists at Morgan Stanley and Merrill Lynch & Co.

Fed officials signaled yesterday they are now as concerned about a faltering U.S. economy as they are about stability in financial markets. The central bankers anticipated growth that was “somewhat more sluggish” than their previous estimate, according to minutes of the Dec. 11 Federal Open Market Committee.

A contraction in the U.S. would drag down economies worldwide, say Goldman Sachs Group Inc. economists, who have dropped their previous view that the rest of the world can “decouple” from America’s economic ups and downs.

‘Recoupling’

Jim O’Neill, chief economist at Goldman Sachs in London, says that “2008 is the year of recoupling.”

The gloomy outlook may be apparent as central bankers including Bernanke, 54, and ECB President Jean-Claude Trichet, 65, gather Jan. 6-7 for meetings at the Bank for International Settlements in Basel, Switzerland.

“Downside risks to growth will trump their inflation concerns,” says Larry Hatheway, chief economist at UBS AG in London and a former Fed researcher.

After three reductions in the U.S. federal funds rate last year, the Fed begins 2008 with the benchmark at 4.25 percent, the lowest since Bernanke became chairman in 2006.

Easier monetary policy isn’t the only tool central bankers are using to relieve strains in markets. The Fed and counterparts in Europe and Canada last month began auctioning cash to money markets in their biggest coordinated action since just after the 2001 terrorist attacks.

Complementary Medicine

Such operations don’t change “the fact that the central banks still need to cut rates,” says David Brown, chief European economist at Bear Stearns International in London. “It is complementary medicine to improve the situation.”

Economists expect more medicine this year, and investors are demanding it. UBS, Deutsche Bank AG and Dresdner Kleinwort, the most accurate forecasters of U.S. interest rates in 2007, say the benchmark will fall below 4 percent this year. Futures trading suggests a better-than-even chance that will happen before April and investors increased bets yesterday the Fed will cut its key rate by a half-point this month.

The central banks’ choice to help growth will be proven right if economic weakness helps bring inflation down anyway. Global price increases will fade to 2.1 percent this year, the lowest since records began in the early 1970s, as growth slows, according to the OECD.

That outcome is far from guaranteed. In leaning toward easier monetary policy, central banks are accepting the risk that lower rates now may mean higher prices later.

Consumer Prices

U.S. consumer prices in November jumped the most in more than two years, while those in the euro area rose at the fastest pace since May 2001. The Fed’s Open Market Committee said Dec. 11 that “inflation risks remain,” and it will “monitor inflation developments carefully.”

King’s Bank of England, like the Fed, may put aside inflation concerns for now. Its Monetary Policy Committee voted unanimously to cut its benchmark by a quarter-point to 5.5 percent on Dec. 6, an unexpected shift after King, 59, had said two weeks earlier that the price outlook was “less benign.”

Alan Castle, chief U.K. economist at Lehman Brothers Holdings Inc. in London, forecasts that the BOE will cut rates twice more by June, or even go to a half-point reduction as early as February.

Inflation Challenge

At the Bank of Canada, a Bloomberg survey of economists forecasts that Governor David Dodge, 64, in his final decision Jan. 22, will lower the benchmark by another quarter-point after having lopped it to 4.25 percent on Dec. 4. The inflation challenge for Dodge and his successor Mark Carney, 42, is less acute because a surge in the Canadian dollar has restrained prices.

Even the Bank of Japan, whose 0.5 percent benchmark rate is the lowest in the industrial world, may need to cut for the first time since 2001, say economists at Mizuho Securities and Mitsubishi UFJ in Tokyo. While most economists expect the BOJ to remain on hold through the first half of 2008, the bank in December cut its assessment of Japan’s economy for the first time in three years.

The ECB has less room to pare borrowing costs as its own economists predict inflation will accelerate next year and stay above their goal of just below 2 percent. Trichet said last month that some of his colleagues already wanted to impose higher borrowing costs as rising inflation proves more “protracted” than they expected.

European Growth

While that may keep the ECB from lowering its main rate from 4 percent, it won’t lift the rate either, says Jose Luis Alzola, an economist at Citigroup Inc. in London. By the last half of 2008, a “modest rate cut is increasingly probable as growth disappoints,” he adds.

If Bernanke and his counterparts do succeed in dodging recession, they may wind up removing the punch bowl by year’s end, following Martin’s maxim about what central banks have to do as soon as the party “gets going.”

“All central banks are likely to face a sterner global inflation environment,” says Dominic White, an economist at ABN Amro Holding NV in London. By the end of the year, some, including the Fed, ECB and BOJ, “could be forced to tighten policy aggressively as growth recovers,” he says.

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