Interest rates remain on hold across the pond.

The European Central Bank and the Bank of England kept benchmark, short-term interest rates the same Thursday, as the major central banks chose to take a wait-and-see stance amid the competing challenges of rising inflation and slowing growth.

The ECB kept its key rate, the refinance rate, at 4.25%; the BOE, its rate on commercial bank reserves, at 5%.

The euro and British pound were little changed versus the dollar after the decision. The euro strengthened about three-tenths of a cent to $1.541 and the British pound strengthened one-quarter cent to $1.9516 in Thursday afternoon trading in Europe.

Rates: tougher call for BOE

London-based economist Mark Chandler told BloggingStocks Thursday the Bank of England's circumstance is "a tougher call for monetary policy markers" than the ECB's.

"In the U.K., inflation is rising and the growth outlook is not good, whereas [continental] Europe has a better GDP outlook. So in that sense the Bank of England has a difficult task, similar to the U.S. Federal Reserve's. They have to find a way to bring down inflation from about 4% to 2% without causing a deeper contraction," Chandler said. "Given slowing growth right now, the best stance was to do nothing." The BOE has cut interest rates three times since December 2007.

We're back to the 1970s. The Washington Post reports that the Fed's Beige Book suggests that growth is stagnant and prices are rising. That's an economic condition known as stagflation -- slow growth and high prices. That's bad news for policymakers and investors.

I first posted about Stagflation back in May 2006. What is striking to me is that the price of oil was $69 a barrel back then and it's almost double that now. Back then I noted that stagflation "prevailed in the US during the 1970s. For example, in 1979, US core inflation, excluding oil and food, rose at a 9.4% annual rate, GDP grew at roughly 3%, and unemployment averaged 6%. Furthermore, this condition was bad for stocks which rose an anemic 0.37% annual average during the decade." I also wrote about stagflation here and here.

Here are three key findings from the Beige Book:

• Weak retail spending - The Post reported that consumer spending was weak, despite the economic stimulus checks from the government that went out starting in May. There was some demand for electronics, and discount stores got a temporary boost. But discretionary spending froze on housing-related items and vacations.

It's a European anti-inflation campaign that will require boldness, creativity, and patience.

That was how one economist described a potential monetary policy tack by the European Central Bank (ECB) for the quarters ahead.

London-based economist Mark Chandler told BloggingStocks that typically, a central bank will increase interest rates to fight inflation. Paradoxically, he's not recommending that the ECB do that now.

"It is a bit of a paradox, but if the ECB raises interest rates it may have the effect of, in fact, increasing inflation," Chandler said. (Euro-zone inflation is presently running at about a 3.7% annualized rate -- well above the ECB 2.0% limit, according to Eurostat.)

Contain commodities prices, contain inflation

Here's how an interest rate hike may hurt inflation's cause: a rate hike would put the euro, once again, in a superior investment position versus the U.S. dollar, causing the already-weak dollar to fall more, Chandler said. As the dollar continues to fall, commodity prices -- including oil -- will continue to rise, as investors seek to preserve purchasing power of the decreased value of dollar-denominated commodities, and as a general inflation hedge.

Just call it stagflation, updated for the globalization era.

Oil's record, 5-year rise, combined with increasing food costs, have increased inflation, reduced disposable income, and slowed the U.S. economy to a crawl, when combined with the effects of the end of the housing boom.

The above sounds like a prescription for a replay of the 1970s' stagflation era, but is it? Not quite, according to Stephen Cecchetti, professor of economics at the Brandeis University International Business School.

Cecchetti told Bloomberg News Thursday a more-flexible economy, with lower stockpiles of goods, increased fuel efficiency, increased worker productivity, and lower wage increases for employees are among the economic differences separating the 1970s and 2008 U.S. economies. As a result, Cecchetti doesn't see a repeat of the 1970s' high inflation/high unemployment levels.

Economist David H. Wang concurred with the above conclusion, but argued that the two major factors in the nation's enhanced ability to cope with large increases in commodity costs and other negative economic factors are energy efficiency and worker productivity.

Fed Chairman Ben Bernanke was in Massachusetts on Monday, speaking at a conference, according to this article. As you can imagine, he had some things to say about the economy. Believe it or not, they were actually encouraging, and it should cause many to feel at least a little more comfortable, even though the world appears to be ending thanks to really expensive oil futures. In fact, if Bernanke is to be believed, we don't have a lot to worry about.

Well, we do have to worry about a few things, but Bernanke believes that a "substantial downfall" in the economy is not as guaranteed as recent market action has suggested. I'm not sure if he's correct about this. With gas prices hitting a record of an average $4 per gallon, the psychological fallout is going to be immense. Add to that the recent employment data, and the economy seems to have found a wonderful recipe for disaster. But what I like about Bernanke's comments is that they too can hold psychological sway. He believes that the net outlook isn't any worse than before, and many observers suspect that he is done lowering rates. While some might look upon that stance as a harbinger of positive tidings, I think we have to remember that Bernanke's hands are tied right now, and that he has been put in a damned-if-you-do-damned-if-you-don't scenario. If he drops rates any further, then the dollar becomes less valuable on a global basis and inflation becomes increasingly problematic. If he pauses, then what about growth? It all goes back to oil and the dreaded specter of stagflation.

"The markets seemed on the verge of a major sea change," says economist David Smith. In his Cyclical Investing Quarterly, he offers a fascinating review of his concerns for the risks that lie ahead.

"Recent economic data provides considerable foundation for Main Street fears and little support for Wall Street hopes.

"Two of the economy's mainstays, housing and autos, continue to tank and consumers are being squeezed between falling real incomes and rising cost of living – notably in energy and food, the two components eliminated from the 'core' inflation indices by those who claim inflation is 'under control.'

"The consequences of these economic stresses can be seen in falling consumer confidence, weak consumer spending, rising bankruptcies among retailers and defaults among un-creditworthy borrowers.

"The knock-on effects include a global crisis in the financial sector, a pullback in U.S. business spending,
mounting layoffs and an uptrend in unemployment, all of which, in my view, pretty much puts the nail in the coffin of the Goldilocks scenario.

"This view is seconded by chief executive officers in the financial-services industry, who placed the likelihood of a recession at 88%, with one in three putting the odds at 100%.

Growth is slowing in all regions of the world, and inflation is rising, but the International Monetary Fund's No. 2 person in charge says a repeat of the 1970s stagflation period isn't likely.

IMF First Deputy Managing Director John Lipsky said the "inflation speed-up must be taken seriously as it creates potentially significant challenges to economic stability," Bloomberg News reported Thursday. However, Lipsky added that a return to 1970s-style stagflation isn't likely, but it cannot be totally ruled out.

Oil, commodity-rooted inflation

Further, Lipsky underscored that the current inflation rise is being driven by a fundamental increase in demand for commodities, primarily oil, and to a lesser extent by supply constraints around the world, Thomson Financial reported Thursday via Forbes.com. Hence, the recent price increases are likely to prove finite, Lipsky added, unless these items keep rising more rapidly than other items.

Economist David H. Wang told BloggingStocks Thursday he agreed with Lipsky's categorization of the most-recent rise in inflation but added that government subsidies may prevent a pullback in commodity prices, especially oil. Classic economic theory holds that as the price of a good rises, people will use less of it. However, governments in China, Venezuela and the Middle East, among other nations, subsidize gasoline/fuel, lowering its cost, which discourages conservation, Wang said. The United States does not subsidize motor fuel at the federal level, but individual states do subsidize heating oil/natural gas for low-income citizens.

Inflation, public enemy No. 1 in the 1970s in the United States, appears to be regaining its former title in the first decade of the 21st century.

But is it here to stay? That depends on the data you're looking at, most economists agree. U.S. inflation is trending higher, but whether it is more structural or cyclical (simply a product of current demand conditions), is the focus of debate in economics circles.

Structural view

Economist Peter Dawson says structural changes are occurring that will keep inflation well above the U.S. Federal Reserve's 2-2.5% comfort zone for years. Those changes include strong demand for commodities in both emerging and developed economies, the U.S. budget deficit and trade deficit, and the weak U.S. dollar.

"What we're seeing today, in my view, is a new economic age. It's not a cliché. We have more than half the world developing at the same time and it has and will continue to place pressure on commodity prices, oil being the first, but now grains / food stuffs and minerals following close behind," Dawson said. "This is creating a whole new cost layer not only in the U.S., but around the world."

A classic market theorist, Dawson does expect higher prices to do what they're supposed to do, eventually: reduce demand. However, with regard to grains, it's difficult to predict the level at which demand will ebb, due to government subsidies. Meanwhile, oil, he said, "is reaching its zenith, probably at $125 per barrel." Further, Dawson believes a sustained $100 oil price will "propel the development of cheaper, alternative energy sources in the next decade" that will enable sufficient global economic growth. But until commodity demand cools and new energy forms arise, you can expect above-average inflation, both in the U.S. and globally.

In his Street Smart Report, market historian and seasonal timing expert Sy Harding takes an in-depth look at the economic outlook, explaining the Fed's concerns over inflation and potential stagflation.

"Investors in their thirties and forties often don't understand why the Federal Reserve sometimes becomes very worried about inflation.

"Their experience has been that, sure, the price of most everything rises over the long-term. But so what? They now pay $30,000 for automobiles their parents paid $10,000 for, and their grandparents bought for $2,000. Homes that sold for $50,000 in a previous generation now sell for $250,000.

"But their income has grown even faster, so their standard of living is significantly higher than it would have been fifty years ago. So what's to worry about inflation?

The Associated Press reports that wholesale inflation rose 1% in January, its fastest rate in 16 years. This is another piece of evidence that the Fed's rapid interest rate cuts are having their expected effect -- reinforcing inflation. And as more economists forecast a recession this year, the looming specter of stagflation approaches ever more closely.

This means that the market will fall this morning, right? Actually, it looks like despite the good news about bond insurers maintaining their AAA ratings, the market has reversed its early upward direction and turned south because the inflation news was worse than expected. This change in the market makes sense to me.

As I pointed out in my stagflation post, these short-term fluctuations are not meaningful for long-term investors. What may be of interest is that during the 1970s -- a period of low economic growth and high inflation -- the market was essentially flat for a decade. It took a 19% Fed Funds rate from then Chairman Paul Volcker to break the back of inflationary expectations and get us on a path of growth.

The New York Times and the Wall Street Journal [subscription required] are both leading with stories about stagflation -- that combination of slow growth and high inflation last seen during the 1970s. Stagflation has been discussed occasionally in the last several months. I posted about it here and here. That first post, written back in May 2006, is interesting to me because much of it could have been written today.

The stagflated U.S. economy is contributing to the record low, 19% approval rating, for the fellow using Air Force One to visit his fans in Africa. (79% of the public disapproves of his handling of the economy.) His support of subprime mortgages in exchange for contributions from lender Ameriquest along with his $1.3 trillion worth of tax cuts, $9.2 trillion worth of Federal debt, and $2.4 trillion worth of wars have put the U.S. on a precarious financial footing -- hence stagflation concerns.

Here are two reasons stagflation matters to you:

• Bills will grow but income won't. Inflation -- as reported by the government -- was up 4.3%. But anyone who has bought gasoline, heating oil, food, or just about anything else has watched their expenses rise dramatically. Crude oil topped $100 a barrel yesterday and wheat is at a record high. Meanwhile, incomes have stagnated -- declining in relation to inflation in the last seven years. With gold nearing $1,000 an ounce, it's clear that many investors have lost confidence in the Fed's willingness to control inflation.

What does the coming year hold for the economy? BloggingStocks' Peter Cohan considers five issues that will factor heavily in 2008.

Stagflation -- high inflation coupled with weak growth -- is a risk. The latest inflation statistics suggest that inflation is running at a 4.2% annual rate. That's way above the 1% to 2% range that then Fed targets. And by cutting rates, the Fed is contributing to inflation. Energy, food, metals, and other commodity prices are rising due to demand from China and India. But the Fed contributes to the price increases because oil prices are denominated in dollars. When the Fed cuts rates, the value of the dollar drops and the price of oil rises, so inflation is certainly going to rise.

The question remains whether the economy will slow down or whether the stimulus from lower rates will keep it growing. My hunch is that the key to economic growth will be the availability of credit for consumers and businesses. As long as U.S. businesses can get enough capital to keep growing and meeting demand from China and India, they will keep people employed. The weaker dollar actually helps the competitiveness of these U.S. exporters since their goods are cheaper in the international markets compared to those of European manufacturers, whose prices are denominated in more valuable euros.

And as long as people remain employed, they will be able to use their credit cards to keep buying things.

Earlier today oil prices had traded higher, as traders were betting that this past weekend's wintry weather would put a crimp in heating oil supplies. Since then, though, oil prices since turned to the downside, dipping under the psychological $90 barrier.

The main reason why oil prices have been falling today? You guessed it ... concerns over the health of the overall economy. Today's concerns are a runoff of last Friday's CPI report, which showed that inflation during the month of November was the highest that the economy had seen in the past two years. This sent the market tumbling to close out last week, and the bears have only continued to push down the market again today.

There has been a growing fear over the past year that the U.S. economy was moving full steam ahead towards a recession. The one thing that has provided some hope was the anticipation that the Federal Reserve would be willing to continue to slash interest rates in order to fuel economic activity and fight off any looming recession.

Alan Greenspan is worried. He believes that high prices married with an economic slowdown could create a mess in the US economy. The condition he describes is widely known as "stagflation". Earnings and growth could lock up but the cost of oil and food could rise rapidly.

According to Reuters, "in an interview on ABC's "This Week with George Stephanopoulos," Greenspan said low inflation was a major contributor to economic growth and prices must be held in check."

Greenspan's analysis adds a new aspect to the assault on the US economy. Slow growth is already a threat due to deteriorating corporate earnings and trouble in the credit markets. Oil prices are obviously pushing up consumer prices.

But, the cost of wheat has just moved above $10 a bushel, a sign the food prices are moving up aggressively. Inflation in China has been driven by increases in the price of food, but that factor has not hit the US economy hard. Not yet.

As the demand for food in emerging markets rises and costs move up because of the fuel component to harvesting crops, prices could continue to press up.

Greenspan thinks that easing by the Fed may be the best way to manage stagflation. But, with oil and food costs moving up around the world, it may not be that easy.

Douglas A. McIntyre is an editor at 247wallst.com.

Market sentiment seems to be favoring the bears again. My cursory research indicates that 65% of investors are again thinking about an impending decline while the other 35% are still cautiously optimistic. It's only seldom in these last few weeks that I came across the occasional person who insists that the bull charge, which began in 2002, shows no signs of relenting. Just the fact that there has been a noticeable increase in the past few weeks (even before these past few days of declines) in the volume of discussions and analysis regarding how to recognize a bear market is coming, how to prepare for it's arrival and what to do when it gets here, signals to me that investors are getting skittish. The funny thing is that it's almost a universally accepted fact that no one can truly predict a bear market turn.

I gave a warning a couple weeks prior to the last contraction that I thought one was coming. That quick downward slide in fact happened. I'm now going on record again as declaring that the bear is coming for another swipe. I expect that this time the cut will go deeper and bleed a bit longer. (Indeed, I originally wrote this post after Tuesday's sell-off, but already this downturn is longer and deeper than the last). Last time around, I sent you that message based solely on gut instinct with little else to back it up. This time, however, I'll clue you in to some of my thinking.