Modest stagflation could be in the cards for the rest of the year, suggests BMO Capital Markets chief economist Sherry Cooper in a research note.

Central banks have swung from fear about the credit crunch crimping economic growth to worries about building inflation. This shift was on display last week as the Bank of Canada surprised markets by leaving rates unchanged. “The Bank now joins the Fed and the ECB in a shift to mounting inflation concern that seems to portend a growing probability of rate hikes down the road. Just how far down the road, of course, depends on the future path of inflation, growth and financial market distress,” Coopers notes.

“While the financial crisis appears to have ebbed, recent worries regarding Lehman Brothers, UBS and others have taken U.S. financial stocks to new lows, and triggered renewed growth concerns,” Cooper adds.

Also, she notes that Fed chairman Ben Bernanke and other Fed officials “have been making hawkish statements regarding the need for inflation vigilance and a stronger dollar.” These inflation fears are building as, Cooper notes, “oil price pressures are filtering through other sectors of the economy, most notably chemicals, plastics and all modes of transportation. Farmers are punished by the high cost of energy, fertilizer and other commodity inputs as food prices have also risen sharply.”

“While the Fed seems relatively sanguine about the possibility of a 1970s-type wage-price spiral as labour markets are weakening, Bernanke is concerned about a potential rise in inflation expectations. Overnight interest rates in the U.S. and Canada may be low now, but Chairman Bernanke seems to be suggesting that the current 2% target Fed funds rate might be hiked before year-end barring renewed economic weakness,” she observes.

Similarly, she says, the Bank of Canada now sees inflation risks to the high side, despite the fact that the economy has “moved into excess supply, which is expected to increase this year.”

“They continue to believe, however, that growth will pick up later this year and accelerate in 2009,” she says, adding, “The Fed as well is heartened by the considerable resilience of consumers over the past five years.”

“For now, central banks are preoccupied with the potential for upside pressures on inflation. While none doubt that the surge in oil and food prices dampens demand and discretionary spending and reduces corporate profitability for most companies, inflation is apparently seen as a bigger potential problem than recession. Financial instability and the credit crunch have, for now, descended in importance,” she concludes. “A moderate version of stagflation may well be the outlook for the rest of 2008.”