Inflation seen hanging over 2008 world economy

By Steven C. Johnson

NEW YORK (Reuters) - Inflation is shaping up to be a serious threat to financial markets and the world economy next year and the timing couldn't be worse, money managers at the Reuters Investment 2008 Outlook Summit said.

Even as prices rise, a severe global credit squeeze has prompted major central banks to flood the banking system with more money than at any time since the September 11, 2001, attacks.

With that much money sloshing around, many fear high prices will push the world into a prolonged period of sluggish growth, with the U.S. economy in particular vulnerable to a rerun of 1970s-style stagflation.

"We're trying to deal with two polar opposite problems here," said Robert Kowit, an international bond fund manager with Federated Investors. "I would say (stagflation) is an increasing concern for most investors."

Stagflation, a combination of stagnation and inflation, describes periods of rising prices coupled with stalled growth.

In the 1970s, things got so bad that the United States had trouble finding buyers for its bonds, sparking a dollar crisis that saw asset prices fall and real interest rates spike.

Kowit said a rerun of that scenario is a top concern heading into 2008. Economists predict falling home prices and the credit crunch will more than halve the U.S. growth rate to 1.4 percent in the fourth quarter. Some see recession ahead.

Interest rate cuts from the Federal Reserve have also accelerated the dollar's six-year decline, sending it to a record low against the euro and potentially raising prices for already indebted U.S. consumers.

"When we talk about what a dollar crisis looks like, at least in my experience, it's been accompanied by a stagflationary environment," Kowit said.

A FLOOD OF MONEY

Fighting inflation has grown more complicated since August, when a rash of U.S. subprime mortgage defaults hit investors who had bought those loans. Lenders then cut off credit to customers because investors stopped buying the debt that banks use to finance home loans.

But efforts to get credit flowing again through infusions of capital will make inflation problems even worse, said Jim Grant, editor of Grant's Interest Rate Observer.

A group of major central banks, including the Fed, joined forces this week to make it easier for banks to borrow and lend money. The Fed said it would hold two auctions through a new funding facility of $20 billion each.

"The risk is that by intervening to facilitate transactions to prevent so-called fire sales, the central banks of the world are actually not so surreptitiously inflating the global money supply in order to lift all asset values, including the ones that are most dubious," Grant said.

But some say the dangers of a seized-up credit market are large enough to justify aggressive action from central banks.  Continued...