The Story Behind the Numbers:

To be sure, this benchmark price that has been swaying markets - not to mention the economy - in recent years ended the week close to where it started and is considerably below the $145 peak reached in early July. But the swift, if temporary, run-up this week provides a stark reminder of how sensitive the U.S. financial markets are to geopolitical upheavals, of which plenty abound. Apart from the resignation of Pakistan's president and the escalating conflicts in Afghanistan, we are now facing another combustible episode that could bear directly on oil prices, namely Russia's militant actions in Georgia. However this incident plays out, it is clear that potential disruptions to oil supplies from geopolitical tensions will remain a fact of life in the foreseeable future.

That means oil prices are likely to swing widely and continue to be a disruptive force in the U.S. economy as well as the financial markets. It's important to recognize, however, that the nation has been living with a volatile oil market for the better part of four decades. While that hardly means a comfort zone has been established - after all, at least two of the oil crises have led to recessions - there is at least a familiarity with the problem that lessens the uncertainty associated with it. Likewise, the U.S. has coexisted uncomfortably with several credit crises for just about as long, stemming from the Penn Central failure that rocked the financial markets in the early 1970s. But unlike the oil quagmire, which largely stems from external uncontrollable forces, the credit crises usually arise from homegrown sources that lend themselves to policy fixes.

Unfortunately, those policy responses often aggravate the problem or create new ones, which is why there is more uncertainty associated with the current credit crisis than with oil price fluctuations. Simply put, investors have developed a somewhat fatalistic attitude about oil price disruptions, since there is practically nothing that can be done about them in the short run. However, credit crises are perceived differently because they are linked with human infallibility, with villains and victims in the mix. Hence, they invariably lead to immediate policy responses that have uncertain -- and often harmful - consequences for the economy and financial markets. The current credit crisis may be no exception, and the ultimate outcome remains as unclear to market participants as when the subprime meltdown first reared its ugly head last summer.

Then, the policy mandate was relatively clear - to prevent the housing bust and credit-related woes from spreading to the broader economy. The financial markets generally accepted the "containment" objective, which led to a series of interest rate cuts because growth was slowing and inflation was not considered to be a threat. In short order, however, it became clear that the aggressive rate-cuts and other special liquidity measures to keep credit flowing were wholly inadequate to deal with a problem that had been greatly underestimated. Not only has the credit crunch intensified and threaten to bring the economy to its knees, the Fed's aggressive moves may be fueling inflation embers that will be more difficult to snuff out later on. Small wonder that the markets are confused and anxious.

To be sure, the Fed continues to present a brave face with regards to the 'flation' part of the stagflation problem. Just listen to chairman Bernanke's opening remarks before the August 22 annual economic symposium at Jackson Hole in Wyoming. In talking about the current policy stance of maintaining a low federal funds rate despite rising inflationary pressures, Bernanke stated that … "This strategy has been conditioned on our expectation that the prices of oil and other commodities would ultimately stabilize, in part as the result of slowing global growth, and that this outcome, together with well-anchored inflation expectations and increased slack in resource utilization, would foster a return to price stability in the medium run. In this regard, the recent decline in commodity prices, as well as the increased stability of the dollar, has been encouraging. If not reversed, these developments, together with a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate later this year and next year. Nevertheless, the inflation outlook remains highly uncertain, not least because of the difficulty of predicting the future course of commodity prices, and we will continue to monitor inflation and inflation expectations closely. The FOMC is committed to achieving medium-term price stability and will act as necessary to attain that objective."

In other words, the Fed is banking on the slowing economy to bring down inflation, a time-honored dynamic that usually works. We have no quarrel with that prospect, but duly note that not all policy makers feel the same way. Indeed, since the Fed started cutting rates last September, at least one member of the policy-setting committee has dissented because of inflation fears. Last week, one of the main inflation hawks, Dallas Fed President Fisher opined … "until we have a clear sense of what will prevail, monetary policy makers must remain poised to act if slowing growth fails to contain inflationary pressures." What Fisher and others are concerned about is that the commodities-led inflation upsurge this year has global roots that may prove intractable in coming months and will ultimately become more ingrained in inflation expectations.

Clearly, the inflation acceleration has been nothing short of astonishing, with both the consumer and producer price indices surging to rates not seen in decades. This week, the Labor Department reported that the producer price index for finished goods jumped to an annual rate of 9.8 percent, the steepest rise since 1981. And while energy and food prices continue to be the major upward drivers, the pass through from earlier increases to the broader index cannot be ignored. The so-called core PPI, which excludes food and energy, is rising at a worrisome 3.6 percent annual rate through July, the strongest increase since 1991. For the most part, the increases in wholesale prices as well as the surge in energy prices on the retail level are not filtering through to the broader consumer price index. Even so, the core CPI has been edging up and is running at a pace that is markedly above the upper threshold of the Fed's comfort zone.

With growth slowing and inflation rising, the current environment is as close to stagflation as anytime since the 1970s. By itself, that condition is not fatal as long as it doesn't persist. If Bernanke's assessment is correct, the 'flation ' component should soon start to recede as more and more slack in the economy opens up. We concur with his perception, but the inflation response may take longer to play out than in the past, sustaining the angst among the inflation hawks. One reason is that the upward pressure on commodity prices, although lessening in recent weeks, will probably remain high due to strong demand for natural resources from developing countries, particularly China and India, where growth remains robust.

What's more, while inflation expectations are well anchored in the U.S. that is not the case overseas, where workers are demanding - and getting - heftier pay raises to compensate for rising prices. This is the kernel for a classic wage-price spiral that is extremely difficult to reverse once it becomes firmly established. However, this spiral is taking root in Europe primarily because of the strength of unions, which have much less power in the U.S. As a result, the European Central Bank has to clamp down harder on growth to resist inflation pressures, which is why it, as well as a number of other foreign central banks, are retaining a tightening bias in their policy stance.

Not so here in America, where wages have been lagging inflation for more than a year and workers have little bargaining power in the face of deteriorating job prospects. Without the pressure from labor costs, a wage-price spiral is virtually impossible to take root. Not only do businesses feel little pressure to pass on higher labor costs to consumers, they risk losing sales if their wares become too expensive for budget strapped customers whose paychecks are not keeping up. But businesses do feel pressure to pass on higher costs of raw materials, which is why the commodity-led price surge will linger on longer than the Fed would like. Still, with the credit crunch in full swing and the housing meltdown continuing, the Fed is likely to focus more on keeping the economy afloat than on bringing inflation down faster. Indeed, this week's housing report, revealing that builders slashed starts in July to the lowest level since March 1991 is ample evidence that the housing drag on the economy is far from over. Whether the Fed keeps rates too low for too long - as many critics believe it did following the dot-com collapse earlier in the decade - and sows the seeds of another bubble-like problem remains to be seen. Until more clarity on the economy, the credit crisis and, hence, policy strategy comes into focus, we suspect that the financial markets will be susceptible to a great deal of uncertainty. Keep your seat belts fastened.