Wall Street's bears are back in charge

“Stagflation is the word — certainly here in the United States — and it's more or less breaking out all over the world,” said Allen Sinai, chief economist at Decision Economics, referring to the dreaded combination of stagnation and inflation.

“And it's putting central banks in a real bind," he said. "For (economic) growth they need to cut rates, but they can’t possible do that. At the end of the day, central banks have to raise rates to fight inflation.”

Fed officials will get another reading on prices this week, with back-to-back reports on the latest monthly data on wholesale and consumer inflation. That news could place the Fed further in a bind; a reading showing rising inflation would increase the need to raise interest rates to try to tamp down price increases.

But raising rates could worsen the ongoing global credit crisis — including the fragile condition of mortgage finance giants Fannie Mae and Freddie Mac. On the other hand, lowering rates to calm the credit markets risks stoking inflation.

As the latest round of corporate earnings reports are released in the next few weeks, investors are bracing for more bad news as financial giants like Merrill Lynch and Citigroup Inc. are again expected to write off billions of dollars of assets. Since last year, banks have written down nearly $300 billion.

“We have to consolidate, recapitalize and resize the entire financial system,” said Sinai. “It is broken, it is cracked. It will take a long time to fix it. You overlay that on what's going on in the economy, and the recession that we are already in and have been in, and the equity bear market is just going to last with occasional interruptions.”

As they work to rebuild damaged assets, banks are also coping with a big drop in profits. Financial stocks in the S&P 500 last year generated $61 billion of earnings; this year, the number is fall below $25 billion, according to S&P.

With a sizable portion of their assets backed by home mortgages, the continuing decline in home prices will prolong the rebuilding process. And with banks under pressure, they’re lending less money to potential home buyers — which further delays the recovery in the housing market.

"You're going to have further price drop as the value of (banks’) collateral is impaired and the mortgages are held on the banks balance sheets will become worthless," said Kevin Caron a market strategist at Stifel Nicolaus. "So it's a self-propagating negative cycle that is going to be difficult to break, but eventually it will come to an end."

Earlier this year, the hope was that aggressive rate cutting by the Fed, coupled with $107 billion in tax rebate checks, would help the economy dodge a recession. The stimulus plan seemed to have the desired effect. Last week retailers reported better-than-expected gains in sales for June.

But the final checks have been mailed and will soon be spent. Then higher prices and rising unemployment are likely to crimp consumer spending, which accounts for some 70 percent of  U.S. economic activity.

“Discretionary spending of all kinds — restaurants, movies etc. — are going to get scaled way back in the next six months to a year,” said Nariman Behravesh, chief economist at Global Insight. “And that will have a dramatic effect on consumer spending and the overall economy.”

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