Same store retail sales are showing signs of trouble, with 26 stores showing negative growth, three of them in double digits.

Despite massive discounting (and, ultimately, profit erosion) Wal-Mart's sales growth dropped from a growth rate of 5.0 percent to just 0.7 percent. Even JC Penney — a prime middle markets store — reported a negative 1.8 percent!

It appears that the decline in consumer spending, as I have long forecast, is now at hand.

CNBC reported that real wages are falling by 1.4 percent.

Some commentators point to a drop in consumer debt as a good sign: Consumers are paying down their debts. It is indeed a good sign in the long-term.

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But as we head into a recession, it is bad news. The American consumer appears to be cutting back.

It is clear that recession is close at hand. Indeed, as I have said for some time, we feel the fourth quarter of 2007 will prove to be the start of a long and deep recession.

Normally, recessions start with a decline in consumer demand and lead to weakening real estate prices.

[Editor's Note: Commodities Are Still in a Bull Market. Get Our Top 6 Recos for the Coming Year.]

What is strange about this recession is that it has been triggered by a major collapse in real estate prices.

In addition, this recession follows a boom during which leverage and liquidity have been at historic highs. I think this bodes ill. It will be a long and painful recession.

A so-called "soft-landing" — a slight recession — calls for strong pre-emptive action by the Fed, a reduction in interest rates. Our Fed has only begrudgingly lowered rates in an effort to avert a credit crisis. Until Oct. 18, there was little mention of recession.

Now, we also see inflation rising. The producer wholesale price of consumer products has come in at a whopping 7.4 percent. Will this increase be absorbed by corporations, reducing earnings, or passed on to consumers and place further upward pressure on consumer inflation (CPI) already running at an annualized rate of 3.6 percent?

Clearly, it will be handled differently by each company, but, either way it is bad news.

So the "stealth inflation" of which I have long warned is now coming out into the open.

It is interesting to note that the Fed has chosen this precise moment to announce a new "transparency" in the way it discusses such matters as inflation.

Has the Fed seen for some months that few observers spotted-stealth inflation?

In short, as the Fed mentioned in its last statement, the forces of recession and inflation are roughly "in balance." Inflation and recession together spells stagflation—a great economic ill.

Was the Fed's statement, therefore, the first official acknowledgement of stagflation? I think, yes!

This is very bad news. But, in addition, our economy is bedeviled by a plummeting dollar.

As we have pointed out in detail before, a falling dollar is both highly inflationary and likely to prove devastating to our balance of payments over the long-term.

Both a stronger dollar and inflation call for higher rates. But, increased rates could drive our coming recession into a depression.

So, our Fed is between a rock and a hard place. That, in my view, is why the Fed has hesitated for the past year. They have talked tough on inflation but left rates on hold, with "real" rates (net of inflation) actually tightening as I warned of a housing bust-led recession.

In view, if they were not prepared either to defend the U.S. dollar or to hit hard at inflation, I think the Fed should have lowered rates very aggressively over the past few months.

I say aggressively because I sense an unusually deep, housing-bust-led recession is ahead and I believe that history shows it takes some nine to 24 months for lower rates to gain traction and stimulate economic growth.

But that is all looking through the rear view mirror.

Today's question is, What should the Fed do? More important for our readers however is, What will they do?

My experience of some twenty years of politics and thirty-five in finance leads me to believe that politics will win — at least in the short-term.

In other words, the prospect of a deep recession, especially in an election year, will bring very great pressure on the Fed (despite its so-called independence) to forget inflation and the dollar's plight and concentrate all efforts upon getting us out of inflation, even if it is late — and late it will be!

Therefore, I see our Fed being encouraged to take decisive action to alleviate recession.

In my opinion, having left major interest rate cuts so late, the Fed will now have to cut its rate by between three and four percent, and soon!

I further feel that, with our dollar poised for freefall, the Fed may act more slowly and indecisively, thus both deepening and lengthening our coming recession.

It all adds up to a financial nightmare, with stagflation raging. However, other nations will also face difficulties. The subprime "toxic waste" has been sold internationally. All economies depend upon the viability of paper money, now threatened by a dollar collapse.

[Editor's Note: Special Report: 5 Ways to Profit From the Housing Bust.]

In the past few days, we have seen both French President Nicolas Sarkozy and Japanese Prime Minister Yasuo Fukuda expressing great concern over the plunge of our dollar.

I feel that we will soon see a series of competitive devaluations and lower relative interest-rate differentials. This may put a floor under our dollar, but do little to prevent the spread of recession from America (still far the largest consumer market in the world) to the world economy. Here I agree with Stephen Roach of Morgan Stanley.

I believe that the recession, I have long warned of is now squarely on the cards.

So what should our readers do?

As I have said before, don't panic. Stick with the asset allocations we have long suggested.

Continue to accumulate cash and short-term Treasuries (including Canadian and Australian) to take advantage of both security and interest rate falls, in the short to medium term.

Sell long bonds and high-yield bonds as there could be further very serious credit concerns and inflation will drive long bond prices down. Continue to hold commodities, especially foodstuffs and gold, even silver.

In the short term, they can be expected to show volatility as investors become aware of recession. But as inflation (within stagflation) continues, they can be expected to rise in the medium term.

Hold private equity positions in good situations, that is, those which will generate large amounts of cash in projects that stand to revolutionize their industries, especially where the end customer is the government or buyers of health or security.

Those with an appetite for risk should look at exchange traded funds (ETFs) that are short the stock markets or retail sector.Go here now for more information.

Editor's note:
4 Foreign Currency Plays to Beat the Falling Dollar.
Will the Liquidity Crisis Sink Your Stocks? 12 Ways to Profit.
Cash and Banks at Risk? Protect Your Wealth Now.
Free Report: The 5 Five Best ETFs You Can Buy Today.