Inflation and Deflation

Good day… A nasty morning here in St. Louis, as we are in the middle of a wicked ice/sleet/snow mix. The drive to work was definitely interesting with several cars sliding on the ice. The dollar slid overnight also, as the markets are starting to realize just how bad the situation is getting here in the United States. Today we will have another set of data, which will likely send the dollar further down the slippery slope it started on yesterday; but first I’ll recap yesterday’s data.

Inflation is back according to the CPI data released yesterday. The year-on-year CPI rate increased to 4.3% in January from 4.1% last month and the core number also increased 0.1%. Just before the release of this data yesterday morning, the dollar started to rally as if there was a leak of the stronger CPI numbers. The housing starts and building permit data actually surprised on the upside, so the dollar continued to run up and didn’t stop rising until a half an hour later. I guess at some point the markets realized that rising inflation probably isn’t a good thing for the economy, and began worrying about the release of the FOMC minutes, which came in the early afternoon.

The FOMC minutes showed policy makers cut their 2008 growth forecasts and said that rates should be held down ‘for a time’. They also called inflation ‘disappointing’ and some foresaw raising rates, possibly at a ‘rapid’ pace once the economy recovers. Fed Chairman Ben Bernanke last week said the Fed is prepared to keep lowering interest rates, but now warned that faster inflation would ‘greatly complicate’ the central bank’s job. So the Fed has really backed itself into a corner by trying to appease the stock markets with rate cuts that really haven’t solved anything and have actually increased the long-term risks our economy faces. Has the Feds dramatic cuts helped to relieve the credit crunch? Not if you look at the Auction Rate Preferred markets. The cuts have only served to support the equity markets and have done nothing to solve the credit crisis.

So how did the Fed miscalculate the dire situation? The Fed heads believed that inflation wouldn’t be a problem, as a global economic slowdown would keep prices down. But as we have been telling readers for months, the global economy isn’t as bad as our own, and has been insulated from a slowdown in the United States, with the emergence of a middle class in China, growing wealth in India, and the integration of the Eastern bloc countries into Europe. Yes, global economic growth will slow as the U.S. continues to be in a recession, but the global economy is not following the U.S. into this recession. No, global economic growth will continue to be led by good gains in Asia and only a moderate slowdown in Europe.

But where does that leave the United States? When you combine slower growth with rising prices you get STAGFLATION. We wrote about this several months ago (or was it a year ago now?) and have reminded readers several times that this is what the Fed was leading us into. And now even the popular press is talking about it. A front page story in today’s Wall Street Journal had everyone on this morning’s investment shows talking about stagflation and how today’s environment is so different than the ’70s. Yes, interest rates are much lower than in the ’70s, but with inflation running out of control, just how long can they stay down? The latest minutes from the Fed suggest we could see a Volcker like increase in rates sometime next year, to try and combat an inflation problem brought on by our own Federal Reserve.

The Fed not only cut their economic forecasts, but also raised their unemployment projections. We will see if the weekly jobless claims numbers released later this morning support the Fed’s latest prediction. Claims are predicted to have increased to 349K from last week’s 248K and continuing claims are also predicted to have increased. Later today we will see the leading indicators, which probably fell in January for the fourth consecutive month. None of this data will support the dollar, so look for it to continue to slide.

The data doesn’t look so bad for Europe. Producer prices in Germany rose 3.3% in January, and Germany’s largest labor union won the biggest pay increase for steelworkers in 15 years. France’s inflation accelerated in January to the fastest pace in at least 12 years, led by higher food and energy costs. Consumer prices climbed by an annual rate of 3.2% up from 2.8% in December. It will be difficult for the ECB to move toward cutting rates, as the inflation and wage data out of Germany suggest there won’t be an easing of inflation anytime soon.

One of the biggest currency houses is now saying that Trichet won’t be cutting interest rates anytime soon. Merrill Lynch & Co. economist Klaus Baader said he doesn’t expect Trichet to lower borrowing costs this year. His view is now shared by economists at Goldman Sachs Group, Inc., ABN Amro Holding, and Morgan Stanley, but conflicts with most economists and investors. And Baader has some history of predicting the moves of the ECB. Two years ago he bucked the consensus by forecasting accurately that Trichet would keep increasing borrowing costs. If the ECB doesn’t come in with a cut, the euro (EUR) would be set to run up to record highs on interest rate differentials alone.

Another economy that looks to keep growing is Switzerland. Swiss producer prices and import prices jumped to the highest level in almost 20 years in January, adding to signs that inflation pressure is mounting. Exports also rose for the first time in three months in January, as booming emerging economies boosted demand for goods such as watches and machines. The Swiss trade surplus rose to 1.22 billion francs from 181 million francs in the previous month. Emerging markets in China and India have replaced the lost sales to the United States. The Swiss franc (CHF) should continue to increase and will continue to be one of the best performing currencies versus the dollar.

As I have touched on a couple of times, the emerging markets of India and China will continue to take up a majority of the slack left by the slowdown in the U.S. economy. Global demand for commodities looks to continue, and should support those countries and economies who have good exports. The combination of demand and increasing inflation pressures has sent gold, silver and platinum to near record levels. $1,000 gold can’t be far off, and platinum has set a record rate of increase. Investors should have precious metals as part of their investment portfolio, and our MetalSelect accounts are an incredibly efficient means of holding either gold or silver. Our award winning MarketSafe CDs also give investors the opportunity to benefit from the increase in metals, but have the added protection of guaranteed principal protection. These are excellent investments for those of you who worry you are buying into the precious metal markets at historic highs.

The Chinese economy isn’t indicating it is going to see the dramatic slowdown some had predicted. Inflation in China hit an 11-year high of over 7%. Consumer prices rose 7.1% after gaining 6.5% in December. The worst snowstorms in half a century disrupted food supplies with prices soaring 18%. Beijing is constrained in the use of interest rates in fighting inflation because of the implications for the renminbi (CNY). With U.S. interest rates falling, China’s central bank is losing billions of dollars a month on the foreign exchange reserves it invests in U.S. dollar instruments to keep the renminbi from rising. I would expect to see China’s leaders let the renminbi accelerate at a faster pace to combat inflation.

Currencies today: A$ .9193, kiwi .8004, C$ .9883, euro 1.4727, sterling 1.9575, Swiss .9080, ISK 67.07, rand 7.7713, krone 5.3431, SEK 6.3240, forint 179.22, zloty 2.4257, koruna 17.0927, yen 108.26, baht 31.48, sing 1.4101, HKD 7.8000, INR 39.92, China 7.1410, pesos 10.77, BRL 1.7114, dollar index 76.07, Oil $99.38, Silver $17.96, and Gold… $943.73

That’s it for today… I’ll close today’s Pfennig on a personal note. Sixteen years ago today I married the woman of my dreams. Instead of a romantic dinner, we will spend the evening shuttling our two children between hockey, batting practice, art class, and a modeling session. Hopefully we will be able to sneak away this weekend for a nice dinner. Looks like we are going to be shorthanded today, as the weather is getting really nasty now. Got to get to it. Hope everyone has a Thunderous Thursday!!

Chuck Butler
February 21, 2008

The Daily Reckoning