Financial Update

· TSX + 111.82(Reuters) Monday as record oil prices bolstered resources and energy shares, offsetting a weak showing by financial services shares on persistent concerns about the credit crunch.
· Dow +35.25
· Dollar -.72c to $97.99US
· Oil + $.60 charged to a new high of $143.67 before settling lower at $142.61US per barrel
· Gold +$4.72US to $936.02US per ounce


Consumer expectations more dangerous than inflation
BARRIE MCKENNA Globe and Mail Update
Ben Bernanke is among a shrinking pool of people who still believe inflation is ebbing.

He and his colleagues on the U.S. Federal Reserve Board's interest-rate-setting open market committee said as much last week. As they left the central bank's key interest rate unchanged at 2 per cent – again – the committee said it “expects inflation to moderate later this year and next year.”
Really?

It's hard to see that scenario playing out. As the price of oil flirts with new highs above $143 (U.S.) a barrel and food prices continue to spike, consumers are braced for just about everything to cost more in the months ahead.

It's what economists call inflation expectations. And the anticipation of higher prices can be as dangerous as inflation itself. When people feel threatened by inflation, they react by demanding higher wages, which push up employer costs, perpetuating the problem.

In Europe, for example, one recent survey of European consumers cites a perceived rate of inflation at 12 per cent. The official inflation rate is in fact running at 3 per cent. There have been protests throughout Europe by fishermen and truckers about soaring fuel costs.

In the United States, the “expected” rate of inflation is running at more than 5 per cent in the year ahead – the highest rate since the 1980s, according to the University of Michigan's survey of consumer confidence. Actual inflation is at roughly 4 per cent.

Consumers may be overreacting to the price of items they purchase most often: groceries and gas. Mr. Bernanke apparently believes the spike in food and fuel prices is transitory and won't affect prices more broadly. He's betting workers and companies won't push wages and prices of other items higher, exacerbating inflation.

Food and fuel prices make up just a quarter of the consumer price index. So why worry?
Instead, the Fed is focused on the downside: the housing crunch, the credit crisis and a slowing economy. If there's inflation, it will be cured by slow growth, Mr. Bernanke has apparently concluded.

So, for now, he keeps the federal funds rate at a historically low level of just 2 per cent – half the rate of inflation.

There is another, more worrying scenario. Speaking in Basel, Switzerland, yesterday, a top official of the Bank for International Settlements urged central banks around the world to keep inflation expectations at bay. Malcolm Knight, the bank's general manager and a former deputy governor of the Bank of Canada, said it would be wrong to assume the recent spike in inflation is just a “blip” that will recede next year.

“We cannot be entirely confident about this reassuring assessment,” Mr. Knight told reporters. He warned of a “clear and present danger” of rising global inflation and inflationary expectations.
In its annual report, released yesterday, the BIS warned that inflation may be the trigger for a much more serious problem: a prolonged period of deflation. The central bank for central banks warned that rising food and fuel prices, coupled with high household debt levels, could send the global economy into a tailspin.

The bank ominously suggested the cooling economy could easily drown inflation, causing “much greater and longer-lasting” economic problems.

Kevin Hassett, an economist at the American Enterprise Institute and a key economic adviser to Republican presidential hopeful John McCain, is among those who worry the Fed has become too complacent about inflation. He frets about a reprise of the devastating double-digit inflation of the 1980s.

“The inflation outlook right now is as scary as it has been since Paul Volcker grabbed his lance and impaled the dragon in 1979,” Mr. Hassett wrote in a commentary posted on the institute's website.

Mr. Volcker was Fed chairman from 1979-1987. Inflation hit 14 per cent as he took the job, and his relentless effort to tame it over the next few years pushed the U.S., and much of the world, into a deep recession.

Let's hope Mr. Bernanke and his colleagues have not forgotten just how painfully high inflation can go – and what it takes to get it under control again.