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Monday October 3, 2005 - 18:04:36 GMT
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Forex: Inflation Genie Out Of Bottle

Inflation was not my call for 2005. But then again neither were two majorahurricanes hitting the oil-rich US Gulf states, China on a shopping spree for oil reserves and potentially a significant slowdown in the rate of productivity growth. Perhaps the only thing checking inflation outside of energy prices has been corporate profits...strong enough to allow firms to eat much of the rise in input prices, which more recently has in places involved higher labor costs. So it is with the slowing in productivity that worries me most on inflation...this will translate quickly into firms being forced to pass on higher prices to customers to protect profit margins.

While we would expect the hurricanes to knock a half to full percentage point off GDP in Q3 and Q4, the latest ISM data for September suggest the manufacturing sector anyway failed to blink at the late-August, and more damaging of the two, hurricane Katrina. New Orleans, is more a service than manufacturing city so perhaps we should not read too much into the September ISM report, but it surely justifies the Fed's take so far that the impact from the hurricanes on the real economy will be quite small and short-lived. Moreover, the surge in the prices paid component in the September ISM report seemed to alert the fixed income market to the rising threat of inflation.
Keep in mind that until the last week or two, the bond market has largely ignored Fed warnings about complacency on inflation and the risks of overheating. Just last week Greenspan said the marvelous job the Fed has done at managing the business cycle has led the market to miss-price economic risk - hence the conundrum. Perhaps the Fed, by managing expectations, has conditioned the market to thinking about was about 18 months ago that the Fed Board was giving key buy- and sell-side participants seminars on deflation. Perhaps the Fed Board should be inviting market mavens down for inflation seminars.

Fed market meddling aside, there is more to the current risk of the inflation genie emerging from the bottle than there was in the spring of 2004 of the deflation zombie emerging from the cemetery. If the federal government spends what it has promised to rebuild weather-vulnerable areas of the Gulf states hit by Katrina and Rita, the jump in government outlays could prove inflationary (even if $200bln is a fraction of overall GDP). Keep in mind it is on top of massive government spending on the war on terror, Medicare (drug prescription benefit to kick in soon) and possibly new tax cuts (albeit it less likely as supply-side math makes for op-ed fantasies, but falls flat with most non-ideologues, including many Republican representatives facing election in November 2006).

Why isn't a high price for energy choking consumption and taking some of the heat off of demand-driven inflation? Because energy was so cheap in the US previously that as it settles to a more realistic rate, consumers are quite happy to pay a premium. Surely not all Americans are as fortunate in the face of rising fuel prices, but those out there spending seem to be unaffected by fuel pump prices. Okay this could change this winter when home heating bills come through the mail.

But, the other driver in the consumption function that oil prices have not deterred is the home ATM machine...home equity lines of credit are still be drawn down to pay for current consumption. So demand seems on track to support higher consumer prices ahead.

And for those monetarists out there, money is still relatively cheap, particularly out the curve (rates the Fed does not control). But even short-term rates are low on a real basis despite 175bps of tightening...core and headline inflation are up nearly as much and more respectively since the Fed started tightening. Without the US economic train derailing, there is no reason why the Fed will stop raising rates anytime soon. Greenspan, eyeing his legacy, can ill afford to go out with an inflation problem (he will be blamed for any inflation problem in the next 12 months, well after he departs January31). Erring on the side of restraint for most is a risk management strategy that the Maestro will deploy through the next, and his last, three FOMC meetings. Moreover, his successor will most surely have to follow a Jan31 Greenspan tightening with one of his or her own March28 or risk being perceived as soft on inflation. That leaves Fed funds at 4.75%, still short of a neutral (real) Fed funds rate if inflation continues to accelerate, even moderately.

So if it is interest rates that tickle your fancy when it comes to currencies (not always the predominant reason for currency appreciation), the near-term outlook for the dollar is quite good. I on the other hand think the US economy must slow and with it see savings rise. The scenario described above of continued strong US growth coupled, a rising dollar, accelerating inflation and a measured pace to tightening will only exacerbate up debt (private and public), bloat the external deficit and increase the chance of a disorderly decline in the dollar in the next year or two. Moreover, the dollar bullish scenario depends ever more on foreign investors buying an increasingly hollow US expansion.

David Gilmore


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