FOMC in Fairytale Land

Good day… The FOMC left rates unchanged, and their accompanying statement showed they have not really changed their overall view of the economy. In Bernanke’s mind, the U.S. economy is growing at a “moderate” pace and inflation remains the ‘predominant’ concern. This is what has been termed a “Goldilocks” economy, not too hot, but not too cold. I would agree only to the point that our current FOMC seems to be living in a fairytale land!

Lets look at the recent data. First quarter GDP, announced yesterday, shows the economy is growing at a 0.7% pace. This is the slowest growth in four years. Bernanke and his crew continue to tell us that they believe the economy will pick up the pace in the second quarter, “despite the ongoing adjustment in the housing sector.” I love the way they have chosen to describe the mortgage meltdown as an “adjustment.” Anyone who has followed the recent news regarding the housing market has got to understand the current situation is a little more than an adjustment!

Even Chuck, who has been on some pretty good pain medication, pointed out the following to illustrate the dangers of the U.S. housing market: “Just woke up from a medicine induced nap to read that Countrywide is being investigated for subprime stuff. There’s a story there my friend. You know what I always say… Where there’s smoke… There’s fire!” Yes there is fire here, and the meltdown of the U.S. housing market will continue to drag the economy with it.

So I don’t buy into the Fed’s assertion that the economy will pick up steam through the end of the year. But let’s look at the other side of the equation – the “not too hot” inflation forecasts. Most economists, including Bernanke, have put the top of the so called “inflation comfort level” at 2%. During the 16 months Bernanke has led the central bank, inflation has never been below 2%. And this is using the Fed’s numbers to measure inflation, numbers that we have demonstrated in past Pfennigs that grossly underestimate the true levels. Just look at the tremendous growth of M3, the inflation gauge used by the ECB and no longer reported by our Fed. Inflation is not contained, and will continue to eat away at our U.S. dollar.

So instead of the Goldilocks economy, which the Fed would like you to believe we have, I see an economy that is way to hot, and way to cold!! I can’t argue with the non-move by the FOMC, but I think the positive spin they are putting on their actions is misleading. It isn’t that the economy is in a “sweet spot”; but that the current state of our economy has backed them into a corner and they can’t move. Right now they are just sitting back and hoping the big bad bears don’t come knocking!

Today we will get some additional data on the U.S. economy, which is expected to show a slight pick up in personal income and spending. We will also see the PCE numbers, which is one of the Fed’s favorite inflation gauges. These data will probably offset each other, with a pickup in personal spending offset by a lower core PCE. The dollar has traded off significantly overnight, so any further adjustments after the data will likely be small. Many traders will be heading off to family vacations today, and the U.S. markets will be thin with next week’s Fourth of July celebrations.

The euro (EUR) climbed back above $1.35 overnight as European business and consumer confidence stayed close to a six-year high in June. Inflation in the Eurozone stayed at 1.9% according to a report released today. The global economy’s fastest five-year expansion since the 1970’s has boosted European exports, prompting companies to increase capacity and take on more staff. While that’s cut the unemployment rate to the lowest on record, the ECB is raising interest rates to prevent inflation from accelerating.

An article in the Financial Times earlier this week illustrated just how bright the future looks for the Eurozone:

“The euro zone’s underlying growth prospects have taken a lasting turn for the better, the International Monetary Fund’s chief economist has argued, in comments that could increase the pressure on the European Central Bank to make a similar judgment call.

“The strength of the economic upswing in the 13-country region continued to surprise, said Simon Johnson. Current estimates of its ‘potential’ growth rate – the pace at which it can expand without creating excessive inflation – might be too conservative, he added. ‘My guess is that potential growth is up a bit, and my guess is that it is down a bit in the US.’ Europe had undergone a long restructuring process, ‘which is really paying off’.”

I won’t argue with the chief economist of the IMF, especially since I agree with what he is saying!

We just got an advance copy of July’s Review and Focus. In it, Chuck talks about our newest WorldEnergy Index CD. As usual, Chuck has had good timing in the introduction of this CD. The four currencies that make up the index, the Canadian dollar (CAD), Australian dollar (AUD), Norwegian krone (NOK), and British pound sterling (GBP) are among the best performing currencies over the past few months.

The Canadian dollar has benefited from the recent tick up in commodity prices while the Norwegian krone and British pound have also benefited from interest rate expectations. But the best performing of these four currencies has been the Australian dollar. The Aussie dollar headed for a fifth quarterly advance against the U.S. dollar as it traded back above 0.85 this morning. There continues to be a strong demand for the Australian dollar as China continues to consume all the raw materials it can get it’s hands on. In addition to the iron ore, precious metals, and agricultural exports, Australia is the largest supplier of uranium, a very important commodity in today’s nuclear world.

Benefiting from both the carry trade inflows and an increased demand for commodities, the New Zealand dollar (NZD) continues to be among the top performing currencies. As I reported yesterday, the stronger kiwi has helped push down their current account deficit helping to strengthen the underlying economy. The New Zealand’s central bank has boosted the official cash rate three times this year and the record 8% rate has helped the kiwi gain 29% in the past 12 months. The central bank may be forced to raise rates further to try to keep inflation down in the growing economy. Knowing they may have to raise rates again, I wouldn’t be surprised if the central bank tries to intervene during the thin trading days of next week. But as in the past, any move down due to currency intervention will be short lived. You just can’t fight the markets!!

Currencies today: A$ .8505, kiwi .7725, C$ .9475, euro 1.3515, sterling 2.004, Swiss .8166, ISK 62.29, rand 7.0703, krone 5.8983, SEK 6.8483, forint 182.11, zloty 2.7891, koruna 21.26, yen 123.41, sing 1.5309, HKD 7.8162, INR 40.7472, China 7.6146, pesos 10.8033, dollar index 82.003, Silver $12.49, and Gold… $650.48

That’s it for today… I am told Chuck is in some pain but doing well and has already starting some physical therapy to get used to his new hip. I know he spent yesterday morning eating a McDonald’s breakfast with his “little buddy” Alex. You see yesterday was Alex’s 12th birthday and it is a tradition that the two of them go to breakfast at McDonald’s. Happy Birthday Alex, take care of your “old man”! Our Jennifer still hasn’t popped yet, but this is her last day on the desk as she is scheduled to be induced on Monday. I head out to Boston with the family tomorrow, so I’ll be writing you from the road throughout next week. Hope everyone has a great weekend, and good luck to Jennifer and John!!

Chuck Butler — June 29, 2007

The Daily Reckoning