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Economic Forecasts

How the Global Crisis Hits Home

Higher oil prices and Japanese woes could deal a body blow to the economy and the markets.

We talk to Mohamed El-Erian, CEO and co-chief investment officer of Pacific Investment Management Company, the world's largest bond fund manager.

How serious is the crisis in the Middle East for the U.S. and global economies? The global economy now has to deal with greater geopolitical risk and higher and more volatile oil prices. Higher oil prices will lower growth, increase inflationary pressures and raise the prospect of stagflation. If oil prices do not rise much more from here, the U.S. will face a stagflationary wind rather than a stagflationary storm. The outlook would change if oil prices rose to the levels experienced in July 2008 -- $147 a barrel. For that to occur, disruptions in the Middle East would need to spread to several other countries.

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Will there be a protracted period of higher oil prices? Oil prices are unlikely to settle back quickly to where they were last summer. We should be prepared to navigate a period of high and volatile oil prices. Households will have less income to devote to spending beyond necessities. Meanwhile, companies will face higher prices for materials and lower profit margins. If sustained, this could limit enthusiasm for hiring.

What are the implications of the disaster in Japan? The Japanese natural disasters, and their aftermath in terms of the instability of the nuclear reactors, add to the fluidity of the global economic situation. Investors must now navigate another set of tragic uncertainties that are meaningful by themselves and that aggravate the global oil-price shock occasioned by the uprisings in the Middle East and North Africa. [Read more about how the disaster in Japan affects investors.]

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What's ahead for U.S. markets? Higher oil prices mean lower stock prices because of the impact on corporate profit margins. The situation in Japan is another headwind to stocks on account of lower global economic growth initially and a growing sense of financial risk. But gold does well during periods of geopolitical tension. It also does well when central banks around the world pump lots of money into their economies to encourage growth, which raises concerns about the debasement of paper currency. Both situations are in play today.

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