Get ready for a 2009

High inflation may keep the Fed from lowering interest rates much further...and that could lead the economy to weaken even more next year.

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By Paul R. La Monica, editor at large

Housing non-starter
Weak housing starts and a low reading on the CPI for January are pushing markets lower.

Crude concerns
Oil prices trading near record highs have added to the woes facing the US economy.

NEW YORK ( -- Guess what, kids: Inflation isn't going away. And that means the Federal Reserve's job is getting tougher.

Oil is hovering around $100 a barrel. And the January Consumer Price Index figures - released Wednesday morning - showed inflation bubbling up.

With that in mind, some see dimming hopes for more aggressive interest rate cuts by the Federal Reserve.

The high inflation figures will "further complicate the Fed's easing campaign," said Ashraf Laidi, chief currency strategist with CMC Markets US, a New York-based brokerage firm, in a note Wednesday morning.

The Fed's "dual mandate" is to foster price stability and sustainable economic growth. And if the Fed keeps slashing interest rates, the risk is that the dollar will weaken further and this could fuel even more big spikes in commodity prices.

The new inflation numbers will make the Fed's latest economic forecasts - which it will release this afternoon in conjunction with the minutes from its last meeting - even more important.

It's unlikely the Fed will predict an actual decline in economic growth. But it's possible the Fed may have to lower its growth forecasts for 2008 as well as boost its projections for unemployment.

In October, the Fed said it expected gross domestic product growth of 1.8% to 2.5% for 2008 and an annual unemployment rate of 4.8% to 4.9%. Laidi wrote that he thinks the Fed will reduce the low end of its 2008 GDP forecast to 1.5% and raise the upper end of its unemployment projection to 5%.

Others think that this year isn't the biggest problem for the Fed.

David Joy, chief market strategist for RiverSource Investments, said his biggest concern now is that the Fed may have to boost rates later this year to keep inflation in check.

If that's the case, the current economic woes are nothing compared to what lies ahead.

"Our forecast is that the economy will be strong enough in the U.S. later in 2008 to cause inflation. That will lead to the Fed raising interest rates and push us into a recession in the latter half of 2009," Joy said.

In other words, we have the classic case of stagflation rearing its ugly head - high inflation leading to slower growth. The Fed can only do its best to combat one of these bugaboos at a time and Joy believes the Fed will eventually err on the side of reducing inflation.

He added that there could be some good news next year. The worst might soon be over for housing and banks. But 2009 could be highlighted by what Joy dubs "rolling sector recessions" - i.e. other parts of the economy start to experience slowdowns even as the credit market recovers.

Joy also predicts that the unemployment rate will head much higher than current levels next year.

Economists at Lehman Brothers also are forecasting a tough 2009...although not necessarily a recession. In a report late last week, Lehman's economists wrote that they see GDP growth in 2009 of just 0.8% and an unemployment rate of 5.7%

The Fed, for what it's worth, forecast in October that GDP will increase 2.3% to 2.7% next year and that the unemployment rate will remain around 4.8% to 4.9%

So something's gotta give. I highly doubt the Fed will lower its targets to levels that are in line with the bleakest forecasts on Wall Street.

But if the central bank doesn't reduce its projections significantly enough, it risks looking at best, Pollyannaish about the economy, and at worst, completely out of touch with reality.

What do you think? Will the economy bounce back in 2009 or is the worst yet to come? To top of page

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