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Markets dive as Fed raises stagflation fears

Section: Daily Dispatches

By Ambrose Evans-Pritchard
The Telegraph, London
Thursday, July 19, 2007

Ben Bernanke, the chairman of the US Federal Reserve, has painted a gloomy picture of slowing growth and rising inflation, causing a sharp sell-off on Wall Street as investors sniff a nasty whiff of stagflation.

The Dow dived 134 points to 13,836 after the start of his annual Humphrey-Hawkins testimony to Congress, and the dollar fell sharply against the euro, yen and sterling. The dollar closed three quarters of a cent lower against the pound at $2.0522 in London.

Mr Bernanke said inflation was now running at 4.4 percent and risked becoming "inconsistent with the objective of price stability," acknowledging that higher food and energy costs had come as a bad surprise. The concern is that the Fed may find itself unable to cut rates quickly over coming months if the economy weakens.

He insisted core inflation was a "better gauge" of underlying trends, an argument meeting growing scepticism in Congress.

Critics say the controversial measure -- expected to run at 2 to 2.25 percent this year -- strips out a big part of household costs by omitting food and energy. While it may be a useful indicator during brief shocks, it is questionable when steady global growth is pushing up all commodity prices. There is mounting evidence that it lags headline inflation by a few months.

Charles Dumas, global strategist at Lombard Street Research, said the US economy was now suffering blows on all sides at once, creating an ugly environment for stocks. He added: "This is a stagflation story. Inflation is going up because of a falling dollar, and rising food and oil prices, and the higher cost of Chinese manufactures. These are external forces and have the effect of cutting disposable income, so the economy must weaken.

"We think the Fed will have to start cutting rates by the Autumn to prevent a hard landing. With mortgage defaults set to rise, the housing slump is clearly set to last until mid-2008 at the earliest."

Mr Bernanke cut his 2007 growth forecast from an upper ceiling of 3 to 2.5 percent, warning that although the worst of the building crisis might be over, lingering weakness would "continue to weigh on economic growth over coming quarters".

In a bid to soothe tempers on Capitol Hill over the Fed's alleged neglect at the height of the sub-prime frenzy, Mr Bernanke slammed the "abusive lending practices and outright fraud" in the mortgage industry and promised to tighten standards in the future.

"Rising delinquencies are creating personal, economic, and social distress for many homeowners and communities -- problems that likely will get worse before they get better," he said.

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