Inflation, Interest Rates, And Short-Term Market View

I think at this point the chances are that interest rates will continue to rise: anybody who knows how to count, knows that the real rate of inflation is closer to 10% than the 3%-4% stated in the announced inflation data (the same goes in Europe) and that slowly, subtly, the Fed (and the ECB with a lag) will begin to acknowledge this.

Personally, as an economist, I think that the economy would be better served with short-term rates at 6% and long-term rates around 8%, reducing liquidity and, hopefully, getting the real level of inflation down to 4%-5% (2%-3% as stated is a joke).

We may be headed for a period of stagflation, or at least slowing growth and stubborn inflation in the next six months, possibly very slow growth or a mild recession in 2007.

Productivity may also rise in the meantime, supporting corporate earnings and so the stock market, and interest rates may not rise as much as anticipated, leaving enough excess liquidity to support emerging markets and international bonds.

But I think the balance of risks is on the side of recognized inflationary pressures, higher interest rates, a draining of some of the excess liquidity, a slowdown in consumption, and a slowdown in growth, at least during the next six months, possibly into 2007. A recession, albeit mild, may even be a good thing.

We'll know better by the end of this year.

Therefore, please quote me your best 3-month and 6-month CD rates at this time.

Erosion of the US Dollar?

May 16, 2006

Seems the dollar has been losing ground as measured by the USD Index. What’s your take on further erosion?

Paul

Hi Paul,

Erosion Of The US Dollar?

There are two ways to view it, fundamental and technical, and the two combined, of course. In either case, the most important underlying factor, assuming political peace and a level commercial playing field, is relative productivity.

Even in the real world, relative productivity is still a major factor.

No doubt that after WWII, the US economy was the most productive, while others, like Germany and Japan, caught up relatively speaking from the 1950s to the 1970s, hence long-term erosion of the dollar's relative value and the end of the gold standard the early 1970s, among other phenomenon like inflation and a couple of oil crises.

The dollar held its own in the early-to-mid 1980s in conjunction with the economic reforms with global reach of the Reagan era, but at the price of high twin deficits. The dollar hit lows in the late 1980s-early 1990s, but right now I don't remember off the top of my head what the low point was against the D-mark, perhaps in the 1.50s area.

The dollar remained mostly strong until the Mexican debt crisis of late 1994/early 1995, dragging the dollar down with it, to a point where it reached 1.34 against the D-mark (about 1.46 against the euro vs 1.28 currently) and 88 against the JPY (against 110 currently). It recovered nicely in the late 1990s in the face of the Asian crisis on the one hand and government budget surpluses on the other.

In late 2004/early 2005 the dollar fell to about 1.36 against the euro (about 1.44 against the D-mark) and around 103 vs JPY.

So the most recent USD lows did not break the all-time low records of 1995.

I'm no technical guru, but usually it takes three attempts for a movement to break through an all-time level. So if we take the EUR/USD at 1.46 in 1995 as the low, the 2004/2005 low of 1.36 can be viewed as a first failed attempt (also USD/JPY at 88 vs 103).

Now we have EUR/USD at 1.28 (USD/JPY at 110) so there is some ways to go to reach 1.36 (103) and eventually 1.46 (88).

Now, I'm not sure that the US economy is relatively less productive than the eurozone economy in the past ten years or even in the past two years, or that its structural problems are relatively worse than those of the EU during the same periods of time, but one can certainly bet either way in view of the massive quantity of US debt – government, trade and household.

For example, this massive investment in oversized, overpriced housing, especially in exburb McMansions, certainly cannot prove to be productive, especially in the face of rising energy prices, unless many people start doing even more highly productive jobs at home and/or we develop an environmentally more renewable and politically safer form of energy to power industry, transport vehicles (both private and mass), offices, and households.

In this context, Europe has been slowly muddling along, and it faces

some highly challenging demographic and structural issues which may

impede new productivity breakthroughs, even if European scientists develop new forms of energy first. Nevertheless, it is conceivable that over the next ten years, the eurozone could become relatively more productive than the US. So the currency bet can go either way, really.

Certainly the Chinese and Indian economies have become relatively

more productive than the US and eurozone economies, at least over the

past three or four years, so there is a strong argument that the Chinese,

and perhaps other east Asian currencies, should rise against the dollar,

perhaps even sharply. The question here is, are Asian consumers, Chinese in particular, ready to pick up the consumption slack that may result from a slowdown or even a recession in the US?

Overall, then, I expect the dollar to remain under pressure against the euro and the other major currencies, especially while the yuan remains, what many perceive to be, artificially low. However, there are enough countervailing factors that argue in favor of further see-saw movements rather than some kind of a dollar meltdown. One key to this, I think, is further rises in US interest rates. I think the Fed needs to keep raising rates, if nothing else than to wring some of the inefficiencies out of the system. But it will continue to tread lightly, trying to maintain a balance

between the countervailing forces.

The long-term way out for this country is to restore social and moral discipline in terms of deficits and debt, production and consumption, on the one hand, and the implementation of more serious energy and transportation policies, on the other, combined with prayer, and some hard, focused research, that we discover better forms of energy, especially, for private vehicle transport, over the next ten years or so.

The biggest caveat, however, is that history teaches us that it is not always wise men who have power and make policy.

So let us hope for the best, and prepare for the worst.

Sincerely,

Steve