"There are risks in both directions, if I may say so. Clearly, we don't want to tighten too much to cause our economy to grow more slowly than its potential. The risk in the other direction is that, were we to stop tightening too soon and inflation were to get higher and more persistent, then we would be faced with a situation of having to address that later on with perhaps even more rate increases," Bernanke added.
Arguing on the side of an immediate cease-fire on rate hikes, Bernanke added, "We must take account of the possible future effects of previous policy actions, that is, of policy effects still in the pipeline. The lags between policy actions and their effects imply that we must be forward-looking, basing our policy choices on the longer-term outlook for both inflation and economic growth," he said.
Then, uttering one of his trade-mark zig-zags, Bernanke said, "High energy and commodity prices combined with low unemployment, and high use rates in factories in plants may sustain inflation pressures in the real economy and would be costly to reverse. The Fed must guard against the emergence of an inflationary psychology that could impart greater persistence to what would otherwise be a transitory increase in inflation," he said.
But while Bernanke is keeping traders in the dark about the Fed's next move, Kansas City Fed chief Thomas Hoenig is more transparent. The two-year series of interest rate hikes have shifted US monetary policy from a "very accommodative stance to a restrictive one," he said. And the next batch of economic data between now and August 8th, should not alter the big picture outlook. "Policy is not made from the most recent data point. It has to be made in the context of accumulated data."
Fed Grows Wary of Inverted Yield Curve
Arguing against a rate hike to 5.50% on August 8th, is the appearance of an inverted yield curve, with the US Treasury's 10-year note yielding 42 basis points less than the US dollar 1-year Libor rate. Historically, an inverted yield curve has signaled an economic recession in the ensuing six-to-12 months. But while US recessions have usually been preceded by an inverted curve, not all inverted curves have resulted in a recession. Bernanke has already hiked the fed funds by 75 basis points in defiance of an inverted yield curve, and is reluctant to push his luck much further.
The inverted yield curve would at least signal slower economic growth, but not spell a contraction of gross domestic product for two consecutive quarters, the typical definition of a recession, anytime soon. The US economy, which grew in the first quarter at a 5.6% pace, the fastest spurt in 2-½ years, is expected to slow to a 3% rate in the second half of this year, according to Fed forecasts.
The Fed's last two rate hikes have knocked the S&P 500 index about 6% off its May 11th highs, and banks' profit margins are getting squeezed, when the short-term rates they pay to borrow money are higher than the long-term rates at which they lend, a situation that can discourage lending and hurt economic growth. Bernanke must also take the US political calendar into consideration, and avoid taking any drastic steps that can hurt the Bush White House in November.
Senator Jim Bunning, a Kentucky Republican, scolded Mr. Bernanke on July 19th, and raised concerns that the Fed will push up rates too high and hurt the economy. Saying he was disappointed in Bernanke's leadership, Senator Bunning maintained that "inflation is not out of control. The Fed is chasing an inflation monster that is just not there," he said, (brushing aside the price of crude oil at $75 per barrel).
Would the Fed follow the Bank of Canada?
Would the Federal Reserve follow the footsteps of the Bank of Canada, which balked at a rate hike beyond 4.25% on July 11th, despite elevated inflation readings and a very tight labor market in Canada? The BOC had lifted its overnight loan rate by 175 basis points since last September, and defended its decision to hold rates steady on July 11th, by pointing to a strong Canadian dollar, which is hurting Canadian exports to the US, which buys 85% of Canadian sales abroad.
"The anticipated moderation of US growth, combined with the lagged effects of past interest rate and exchange rate increases, brings aggregate supply and demand back into balance," the BOC said on July 13th. Beneath the surface however, the BOC is wary of raising short-term rates further, after its last rate hike in May, briefly inverted the Canadian yield curve, hurting the profit margins of Canadian banks.
The Bank of Canada often coordinates its interest rate maneuvers with the Fed, and its decision to hold pat at 4.25% on July 11th, might be a tip-off that it expects the Fed to pause its rate hike campaign at 5.25% on August 8th. In the event the Fed surprises the market with a quarter-point rate hike to 5.50%, it wouldn't sadden the BOC to watch the Canadian Petro-dollar tumble from its 15-year highs.
But the Bank of Canada has the luxury of taking a breather on rate hikes, despite elevated core inflation numbers, because it enjoys a strong Canadian dollar, that helps keep import prices down. On the other hand, the Federal Reserve is the guardian of the chronically weak US dollar, beset by massive external deficits, and so a premature rate pause by the Fed carries much bigger risks, and can badly tarnish its anti-inflation reputation. If necessary, the BOC could hike its overnight loan rate again later this year, without a blemish on its anti-inflation record.
The Fed's Dilemma, Defend the US Dollar or US Home Prices
A slowdown in the US housing market is thought to have been a big reason why US retail sales fell 0.1% in June. Re-sales of single-family homes fell 1.5% in May to an annual rate of 5.82 million. Buyers are discouraged by 30-year mortgage rates that rose to 6.71% last week, the highest since May 2002. The supply of existing homes rose 5.5% to 3.6 million units or 6.5 months' worth at the end of May.
Up to 40% of US home loans were of non-traditional types such as adjustable rate and no-money-down mortgages in 2005. "Some people will soon be faced with adjustable rate loans re-pricing under less favorable conditions," said Chicago Fed chief Michael on May 18th. Another Fed rate hike to 5.50%, would put a greater crunch on Americans who are borrowing more and saving less to support their shopping habits. The US personal saving rate as a percentage of disposable income, slipped to a negative 1.7% in May.
Housing accounted for a third of total US growth and about half of private payroll jobs created since 2001. Fed data shows home price appreciation helped add $5.2 trillion to consumers' balance sheets during the current expansion, or 68% of all wealth creation. So further rate hikes by the Fed to fight inflation carries a big risk of tipping the US economy into an outright recession.
The last three Fed rate rates under Bernanke's watch, were initiated in defiance of an inverted yield curve, and did tremendous damage to US homebuilder shares. Fed officials have downplayed the predictive powers of the yield curve, and have pressed on with the rate hike campaign to defend the US dollar from speculative attack, and to contain surging gold and commodity prices. But after a 50% correction in the DJ Homebuilder index from record highs in August 2005, bargain hunters are sifting through the rubble of the once high-flying US housing sector.
As for the Fed's next move on August 8th, the odds favor a pause in the rate hike campaign at 5.25%. Politics is becoming a key consideration now. A Bloomberg/Los Angeles Times poll on June 27th, showed by a 65% to 22% margin, that Americans oppose another rate increase by the Fed, worried about the value of their homes, and rising mortgage payments on variable loans. Therefore, the politically correct modus of operandi is to maintain a steady fed funds rate at 5.25% in August.
The Bernanke Fed would sub-contract the job of fighting global inflation to other central banks. But a premature pause in the Fed's rate hike campaign in August, could also knock the US dollar lower, while other central banks are tightening their monetary policies. A weaker US dollar, in turn, could put a floor under gold and other key commodities like crude oil and base metals, and lift US import price inflation.
Gold has been on a wild rollercoaster ride this year, mostly tracking the direction of global stock markets for real-time clues about the health of the global economy and inflationary pressures. With the initial outbreak of war between Hizbollah and Israel, gold detached itself from the MSCI World index in mid-July, with the yellow metal moving higher, while global stock markets were tumbling lower.
After peaking at $675 on July 17th however, the fortunes of gold and the MSCI world index reversed, with gold sinking to as low as $600 /oz, and global stock markets rebounding higher. The reversal of fortunes was based on the perception that the Lebanon war won't spread to Iran and Syria. After all the see-sawing, both gold and the MSCI World stock index have moved back into alignment. At other times, gold has tracked crude oil prices, blurring the focus of gold traders.
Federal Reserve banking on Steady Oil prices
Fed chief Ben Bernanke is betting on steady oil prices in the months ahead, to help smooth out the US inflation rate, and justify a rate pause in August. On July 19th, Bernanke said that a "moderation in economic activity that should help to limit inflation pressures over time," implying that a soft landing for the US economy can also keep oil prices, gold, and the "Commodity Super Cycle" under wraps.
However, Bernanke made similar comments on April 17th, when the price of crude oil settled at $70.40 per barrel. "In the longer run, these inflation effects should fade even if energy prices remain elevated, so long as monetary policy keeps inflation expectations well-anchored by responding appropriately to future price and output developments. While the increase in energy prices had pushed headline inflation up sharply, the impact on core inflation appears to have been relatively modest."
No doubt, we shall hear more brainwashing by Fed officials about the low "core" rate of inflation that strips out the bare necessities of life. But even the radical inflationist, ECB chief Jean Claude Trichet acknowledged on July 12th, that high oil and commodity prices demand close attention, and should not be ignored when measuring true inflation levels in the Euro zone. "The phenomenon we are observing is very important and we have to understand it," he said.
Since Bernanke's off-target prognostication on April 17th, the price of crude oil has climbed $5 to $75.50 per barrel. From the chart above, the Fed has been chasing oil prices with baby-step rate hikes since mid-2004. However, in order to merely catch-up with the upward spiral in crude oil prices, the Fed would need to target the fed funds rate at 6%, but that would surely sink the US housing markets.
The Fed can no longer keep pace with spiraling oil prices, and must rely on the Bank of Japan, the ECB, and other central banks to rein in crude oil prices. But crude oil is the kingpin of the "Commodity Super Cycle" and only surrendered about $5 per barrel, during the global stock market meltdown from May 11th to June 13th, before recouping its losses and setting new record highs in July.
Betting on foreign central banks to contain oil prices is just a pipe-dream. The European Central Bank is inflating the Euro M3 money supply at an 8.9% annual clip, designed to insulate the European stock markets from the rising costs of energy. The ECB's monetization of crude oil is starting to backfire, with European headline inflation creeping higher, due to the rising cost of energy and its secondary knock-on effects. The widely telegraphed ECB rate hike to 3.00% on August 3rd, won't put a dent in the Euro M3 money supply, nor undermine the price of crude oil.
The Bank of England, has been conspicuously absent from the G-10's monetary tightening campaign this year, Instead, the BOE is quietly inflating the British M4 money supply at an annualized rate of 11.7%, twice the growth rate from three years ago, to insulate the British stock market from the shock of escalating oil prices. London futures traders are now betting on a quarter-point rate hike by the BOE to 4.75% this year, but still "too little, too late", to rein-in the UK's M4 money supply, or the high flying crude oil market.
Short-selling the Footsie-100 is like pushing a balloon under water. The Bank of England's ultra-easy money policy has enabled the UK's Footsie-100 index to recover three-quarters of its losses from the global stock market meltdown of May 11th to June 13th. With the UK's M4 money supply expanding at an 11.7% clip, the Footsie-100 has also withstood two major oil price shocks this year, aided by energy and mining companies, that make-up about a third of the index's capitalization.
However, the double-digit M4 money supply growth combined with a rising UK stock market, lends indirect support for crude oil and other commodities, so in essence, the BOE is contributing to world-wide inflation. Eventually, the BOE could come under heavy criticism from other central bankers within the Group of Seven, who are raising their interest rates to drain the global swamp of monetary liquidity.
And there is also growing demand for crude oil in China that keeps oil prices bubbling. China's crude oil imports for the first five months of 2006 were up 17.9% at 12.4 million tons, importing more than 40% of its crude needs. China has just completed oil storage tanks in Zhejiang, Shandong and Liaoning, with capacity to hold up to 88 million barrels, and is planning another 200 million barrels of storage, with $941 billion of FX reserves to fund the crude oil build-up.
China is also monetizing the price of its crude oil imports, by inflating it M2 money supply by an average of 17.5% over the past five years. The scope of the PBoC's super-easy money policy can best be measured by the level of China's 7-year bond yield, where yields fell to as low as 2.75% in the first quarter of 2006, from 5.00% in late 2004. Beijing is printing large amounts of its currency, the yuan, in exchange for foreign currency inflows acquired by an external trade surplus and foreign direct investment, in order to keep the yuan pegged at a fixed rate to the US dollar.
The People's Bank of China has started to tighten up the M2 money supply however, and drained 120 billion yuan ($15 billion) thru the sale of short-term Treasury bills. Combined with a 1% increase in bank reserve requirements to 8.5%, the PBoC has drained about 420 billion yuan over the past six weeks. Still, the central bank's latest tightening moves are actually quite gentle, when compared to the more than 7 trillion yuan ($875 billion) of liquid assets held by local banks.
Until the European central banks, the PBoC, and the Bank of Japan begin to raise interest rates in a significant way, global liquidity would remain abundant, and strong speculative demand for global stocks, gold, base metals, crude oil, and other commodities would remain intact. The PBoC might need to lift reserve requirements to 10% by early 2007 to staunch the flood of yuan liquidity, and guide the 7-year bond yield 2% higher towards 5%, to slow its economy to a sub-10% growth rate.
Meanwhile, a rate pause by the Fed in August would probably be taken as a peak in the fed funds rates by knee-jerk hedge fund traders, triggering jubilant celebration in global stock and bond markets. However, a rate pause might also allow inflationary pressures in the gold and commodities markets to become more firmly entrenched, and force the Fed to hike the fed funds rate after the November 4th elections, with its credibility tarnished by politics.
28 July 2006
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Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.
As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.
He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.
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