Monday, August 14, 2006

Stagflation a Real Possibility

Today's rally fizzled. Despite being up more than 100 points in the middle of the day, the Dow eked out only a 10 point gain.

The initial rally was credited to BP's announcement that it won't completely shut down production in Prudhoe Bay. The apparent end to fighting between Israel and Hezbollah also helped push stock prices higher.

But the gains melted away when investors became pessimistic about the PPI and CPI numbers, which will be released over the next two days. The fear is that inflation is running higher than the Fed's comfort level. Despite the recent pause, investors are afraid the Fed will have to resume raising rates.

The Fed is in a pickle. Economic growth is slowing, but inflation is rising. The Fed stopped raising rates because it was more worried about slowing growth than rising inflation. But if this week's inflation numbers are higher than expected, the Fed will have to push interest rates higher.

The Fed has been hoping that slowing growth would reduce inflation. But so far at least, there isn't any evidence of that. If Wednesday's core CPI comes in at 0.4% or higher, stocks could suffer a strong sell-off.

In addition, keep an eye on housing starts, which will also be announced on Wednesday. The housing market has been slowing faster than many on Wall Street had expected. Anything less than 1.8 million starts will contribute to Wednesday's stock market sell-off.