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Stag, Hyper & Gold Price Inflation

The looming battle over inflation between the world's top two central banks...

HYPERINFLATION in the world's commodities markets is rivaling the US housing collapse and the global banking crisis as the No.1 threat to the global economy, writes Gary Dorsch of the Global Money Trends letter.

   Finance ministers from the United States, Canada, Japan, France, Germany, Italy, Britain, and Russia have all expressed their alarm over the doubling of food, energy and raw material prices from a year ago. That's now pushing consumer-price inflation rates around the world up towards their highest in three decades.

  • Crude oil briefly touched $140 a barrel and the price of corn – used to make ethanol – hit $8 per bushel;
  • Chinese steelmakers just agreed to pay 96% more for iron ore from Australian miner Rio Tinto, a five-fold increase since 2003;
  • Steel prices have soared almost 50% this year, as coal and iron ore prices continue to climb and global demand shows little sign of abating;
  • Dow Chemical is raising prices on a wide range of its products by 25%, due to sharply higher energy and raw material costs.

   Sharply higher shipping costs, driven by rising oil prices, have also increased the cost of transporting a standard 40-foot container from Shanghai to the United States from $3,000 (back when oil was priced at $20 per barrel) up to $8,000 today (with crude oil around $135 per barrel) according to CIBC World Markets analysts Jeff Rubin and Benjamin Tal.

   Hence the Baltic Dry Index, which monitors merchant shipping costs on forty major export routes for dry commodities, is 50% higher from a year ago.

On Monday 16th June, South Korea's president, Lee Myung-bak, noted how inflation poses the biggest challenge the global economy has faced in 30 years. "It's no overstatement to say that the world is faced with the gravest crisis since the oil shock of the 1970's, with oil, food and raw materials prices skyrocketing," he said.

   One week later, Myung-bak switched his government's top policy goal to fighting inflation. Within hours, the Bank of Korea (BoK) sold $1 billion from its foreign currency stash to bolster the Korean Won against the Dollar and help keep import costs down.

   Smaller-tier central banks are meantime moving to combat these huge inflationary pressures, applying tougher monetary policies. The Reserve Bank of India (RBI) raised its key lending rate by a half-point to 8.50% – the highest in six years – and increased the ratio of deposits banks must keep with it by 50 basis points to 8.75%.

   With inflation now raging at 11% per year, the Bombay Sensex index just fell below 14,000 points for the first time in 10 months after the RBI tightened it monetary policy. The Indian stock market has lost more than 30% in 2008, one of the worst performing Asian indices this year.

   Over in Beijing, the Chinese authorities lifted retail gasoline and diesel prices by 18% in mid-June, the first hike in eight months and biggest ever one-off rise, as subsidizing retail prices at the previous rates simply became too expensive.

   The move could push the overall inflation rate to 9% in July, however. The People's Bank of China (PBoC) also hiked the bank reserve ratio by a full-percent to 17.5%, soaking up 422 billion Yuan and knocking the Shanghai stock market 14% lower over the next four days.

   "Surely higher energy prices will put some pressure on the CPI, so we may need a stronger policy against inflation," warned PBoC chief Zhou Xiaochuan on June 20th.

   Brazil's central bank meanwhile hiked its overnight Selic interest rate by a half-point rate to 12.25% on June 5th, aiming to bring inflation down from a two-year high in Latin America's commodity powerhouse.

   This latest half-point rate hike pushes the real interest rate, adjusted for inflation, to 7.25%, the highest among the world's top 52 economies.

   And on June 19th, Brazil's central bank chief Henrique Meirelles signaled a third rate hike. Futures contracts in Sao Paulo now project a 1% Selic rate hike to 13.25% by year's end.

   "It is necessary to slow domestic demand in order to balance the whole equation and to avoid the pass-through of the wholesale price increases as a result of the raw materials component to retail prices," central-bank chief Meirelles warned after inflation in Brazil climbed from an eight-year low of 3% in March 2007 to 5.9% in the 12 months to mid-June.

   That's way above the bank's 4.5% upper target. And Brazil's central bank expects the inflation rate will accelerate further to 6.3% in the third quarter of 2008.

   Buoyed by rising returns paid to cash, the Brazilian currency – the Real – strengthened to 1.591 to the US Dollar, a nine-year high. It's gained 9% so far this year, the biggest advance among the 16 most-traded currencies vs. the US currency.

   South Africa's central bank also hiked its overnight repo rate by 50 basis point, taking it to 12% to counter surging inflation and extending a tightening cycle that has lifted the lending rate 500-basis points higher since June 2006.

   Consumer price inflation in South Africa still hit 10.4% year-on-year in April, however, and producer prices are 12% higher. Eskom, the state-owned energy utility, is raising its electricity prices by 27% thanks to a doubling of coal prices from a year ago. RBSA chief Tito Mboweni is warning the markets of higher interest rates ahead, and "Yes, it will be painful," he said on June 23rd.

Fed vs. ECB in Global "Stagflation" Fight

   Thus the central banks of fast-growing emerging economies are trying to navigate their way through the stormy seas of commodity hyper inflation by tightening monetary policies.

   In the developed world, however, the "Group of Seven" central bankers (G7) have acted in a different fashion.

   The British, Canadian, and US central banks are focused on the global banking crisis – as well as the slide in Anglo-Saxon home prices – lowering their interest rates to stem the drop. The Bank of Japan has stood motionless, meantime.

   But the European Central Bank (ECB) has moved in the opposite direction, talking open-market Eurozone rates up to their highest in seven years even before it actually acts to raise its overnight rate.

   When powerful central bankers clash like this – moving in opposite directions on the same problem – nasty accidents can happen in the global stock markets. Tighter monetary policies in the emerging economies is an interesting side-show, but what is really rattling the global stock markets these days is the looming battle of wits between the two most powerful central banks, the Fed and the ECB.

Washington and Frankfurt hold diametrically opposite views over how to cope with the twin evils of the "Stagflation" trap.

   "The world has been staging a run on the greenback, with damaging results if it continues," warned former US Fed chairman Paul Volcker on April 9th.

   "Concerns about recession are rife, and the Fed will be tempted to subordinate the fundamental need to maintain a reliable currency to the impulse to shore up a flagging economy.

   "The danger is that you lose both battles, as in the 1970s, and wind up with stagflation" – the double trouble of a stagnating economy plagued by high and rising inflation.

   Since the sub-prime mortgage debt crisis erupted into full bloom last summer, the Fed has chosen to counter the "Stag" part of the equation alone, slashing its Fed funds rate 325-basis points to 2.0%.

   That's far below the consumer-price inflation rate. The immediate impact for investors was clear to see in the near-50% jump in Gold between Sept. and mid-March.

   American consumer confidence has meanwhile plunged to a 16-year low, largely due to a 18% erosion in home prices since the middle of 2006. That's slashed $4 trillion off household wealth, some $50,000 for each US homeowner.

   However, the European Central Bank (ECB) wasn't deterred by its own plunging Euro-Stoxx banking sector. Instead, it stayed focused on talking tough against commodity-price hyperinflation and trying to curb double-digit money supply growth.

   The ECB guided the three-month Euro Libor rate up to 4.95%, its highest in seven years, and utilized a stronger Euro to partly shield the Eurozone from the "Commodity Super Cycle" now wreaking havoc on US-Dollar linked economies from Hong Kong to the Persian Gulf and back home to the United States.

   As it was, the Fed's aggressive rate cuts couldn't staunch the bleeding in the US banking sector, nor end the slide in US home prices. The Fed's "super-easy" money policies are bound to fail, in the opinion of the ECB, since only a "sound money" policy is the bedrock for a healthy economy.

   "Challenging as the present global economy may be, the rules for monetary policy-making are not altered," said ECB chief Jean Claude Trichet on June 3rd. "Inflation is a monetary phenomenon in the long term and price stability is the responsibility of the monetary authorities.

   On Jan. 23rd, he'd already stated that "in demanding times of significant market correction and turbulences, it is the responsibility of the central bank to solidly anchor inflation expectations to avoid additional volatility, in already highly volatile markets."

   Put another way, "in this new financial landscape, monetary policy has a stability dimension that central banks simply can no longer ignore," said Bank of Italy chief Mario Draghi on June 11th.

   "Central banks need to consider persistently rapid growth of money and credit aggregates as early warnings of financial imbalances, and thus to monitor a wider set of indicators, and not just inflation statistics."

Is the ECB Hijacking Fed Policy?

   Crude oil prices have multiplied seven-fold since 2001, and surged 40% since January. Yet the hyper-inflationists at the Bernanke Fed and US Treasury – the so-called "Plunge Protection Team" standing behind Wall Street with political muscle – didn't recognize how their cheap dollar policy would backfire on the US economy and stock market. Not until crude oil prices jumped $16 per barrel in two sessions (June 5-6th).

   The "crude oil vigilantes" are now energized, ready to jack-up oil prices whenever the Bernanke Fed shows a willingness to devalue the US Dollar still further. So recognizing that his devaluation game had run its course, Fed chief Bernanke did a 180-degree turn on June 3rd and vowed to defend the Dollar – just as Paul Volcker had advised nearly two months before.

   "We are attentive to the implications of changes in the value of the Dollar for inflation and inflation expectations," Bernanke told the International Monetary Conference in Barcelona, Spain.

   "The Fed's commitment to price stability and maximum employment will be key factors insuring that the dollar remains a strong and stable currency," he said, signaling an end to the Fed's rate-cutting campaign.

   However, the ECB hawks seized upon Bernanke's vow to defend the US Dollar, immediately telegraphing – in no uncertain terms – a baby-step rate hike for the European currency to 4.25% when it next meets at the start of July.

   The ECB hawks have been itching for months to lift their repo rate, anxious to combat inflation, which is raging at a 3.7% annual clip in the Eurozone, its fastest in 16 years. And with Bernanke apparently tempted by the idea of tackling US inflation, now they could signal this hike without sending the Euro even higher on the forex market.


   "We could decide to move our rates a small amount in our next meeting in order to secure the solid anchoring of inflation expectations," said ECB chief Jean-Claude Trichet on June 5th.

   "The ECB is not split," agreed Bundesbank chief Axel Weber the same day. "We have sent a clear message to the markets about what to expect in the near future. We have to let deeds follow words."

   The benchmark two-year German Schatz yield soared by 80 basis points to a seven-year high of 4.80% after these warnings. That snuffed out the rally in the German Dax stock-market index at the 7,200 level.

   The ECB isn't afraid to pay the price of weaker Eurozone stock markets, in other words, in order to keep inflation under control. Its clear signal on rate hiking also jolted the German 10-year bund market, which plunged into a free-fall to its lowest levels since July 2007. That lifted medium-term bund yields to 4.65%.

   Given the close synchronization in the G-7 bond markets these days, however, these seismic events in Frankfurt are also being felt in inflation-friendly Tokyo and New York, where government bond markets also came under attack by the global inflation vigilantes.

   The downward spiral in the German bund market widened the Euro's interest-rate advantage over the US Dollar, leaving the greenback on shaky ground and vulnerable to speculative attack. And Bernanke would come under heavy pressure from the bond market to match a second ECB rate hike – if it arrives – to 4.50%. He'd need to defend the value of the Dollar.

   In essence, the ECB could hijack US monetary policy, and force the Fed to guide the Federal funds rate higher in order to shake-out speculators in the crude oil and commodities markets.

   The US Treasury's "Plunge Protection Team" (PPT) has fought a relentless campaign to prevent a bear market from materializing in the Dow Jones Industrials. The PPT's unleashed its entire arsenal – the largest Fed rate cuts in 25 years, negative (real) interest rates, swapping Treasuries for risky mortgages, $165 billion in tax rebates, and intervention in stock index futures.

   The PPT also convinced the Banks of Canada and England to lower their lending rates to provide artificial life-support for the US Dollar against the Loonie and the British Pound. But the PPT's safety-net for the Dow Jones Industrials was ripped apart by the ECB hawks, plunging 100-points and led lower by the plummeting German bund market.

   Two-year US Treasury-note yields just put in their largest weekly increase in 26 years as Bund yields jumped on the ECB's promise of a 0.25% rate hike at the start of July. So to put out the fire, the Fed leaked word to syndicated columnist Robert Novak on June 16th that Bernanke wouldn't be bullied into rate hikes by the ECB.

   "Speculation that the Fed is about to begin inflation-fighting interest rate increases appears to be dead wrong. Bernanke disagrees more with the European position than is reflected by his public statements," Novak wrote.

Greenspan Speaks on Inflation & Rates

   Furthermore, the "Fed chairman feels high oil and gasoline prices threaten contraction more than inflation. The depressing impact on the oil-driven American economy is especially menacing in his view," Novak added.

   Yet sky-high energy prices can inflict more damage to the US economy and the stock market, than a few baby-step Fed rate hikes to stabilize the greenback.

   The point of maximum stress would occur if the ECB carries out a second rate hike to 4.50% in September. That would put enormous pressure on Bernanke to hike US interest rates to defend the dollar.

   Even the godfather of the US sub-prime debt crisis, "Easy" Al Greenspan, knows this, saying on June 13th that "If you're going to keep inflation rates down, the Fed is going to have to put increasing pressure on the money supply and reserves, and as a result we're going to see interest rates rising."

   On June 25th, Trichet held his cards close to his chest. "I didn't say that we envisage a series of rate increases," he quibbled. "That being said, of course, we never pre-commit. The observers in the market know that pretty well."

   However, the central bank chief of the Netherlands, Nout Weilink, said tackling inflation must take precedence over slowing growth.

   "It is way too early to judge what should happen in the second half of this year. This means all options should be kept open."

Bank of Japan Also Inflating the Crude Oil "Bubble"

   Venezuela's energy minister Rafael Ramirez and Opec chief Abdullah al-Badri agree that oil markets are well-supplied, and that sky-high oil prices have nothing to do with global production levels.

   "The US economy is in a crisis that is devaluing the dollar and boosting the price of oil and food around the world. Financial speculators are migrating to futures contracts, which are considered safer than other investments," Ramirez explained this week.

   But while the weak Dollar vs. the Euro gets most of the blame for the sky-high price of crude oil, the Dollar's strength against the Japanese Yen is also elevating the energy markets these days.

   The Bank of Japan (BoJ) has kept its overnight loan rate pegged at 0.50% for sixteen months, which is nurturing inflation worldwide. Global "carry traders" are borrowing Japanese Yen at 1% or less, and converting the Yen into US Dollars in order to purchase energy futures in New York.

   In his first major blunder, rookie BoJ chief Masaaki Shirakawa scrapped his predecessor's policy of gradually raising Japan's borrowing costs, and signaled a green light for "carry traders" to bid oil prices higher.

   "The outlook for economic activity and prices is highly uncertain. It is not appropriate to predetermine the direction of future monetary policy. We need to pay utmost attention to the downside risks to the economy," he said on May 12th, switching to a neutral policy.

   Now the BoJ's super-low interest rates are boomeranging on the Japanese economy. Wholesale prices for petroleum, coal, and gasoline prices are up 28% from a year earlier. Japan's oil import bill soared 53% to $12 billion in May, and soaring steel and iron ore prices are hammering Japanese carmakers such as Honda and Nissan, whose operating profit might drop 32% this year.

   Japan's total import bill is up 12% from a year ago, narrowing its trade surplus by 46% to ¥485 billion ($4.7 billion). A half-point BoJ rate hike to 1% is necessary to shake-out the "yen carry" traders in the energy markets. But don't count on it anytime soon.

   The price of Gold in Japanese Yen just moved back above ¥3,000 per gram, a key level for Tokyo investors who remember the surge in world Gold Prices of the late '70s and early '80s.

   What might the Bank of Japan's refusal to stem commodity-price inflation – and its impact on Japanese exporters – mean for the world's traditional safe haven asset from here...?

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GARY DORSCH is editor of the Global Money Trends newsletter. He worked as chief financial futures analyst for three clearing firms on the trading floor of the Chicago Mercantile Exchange before moving to the US and foreign equities trading desk of Charles Schwab and Co.

There he traded across 45 different exchanges, including Australia, Canada, Japan, Hong Kong, the Eurozone, London, Toronto, South Africa, Mexico and New Zealand. With extensive experience of forex, US high grade and corporate junk bonds, foreign government bonds, gold stocks, ADRs, a wide range of US equities and options as well as Canadian oil trusts, he wrote from 2000 to Sept. '05 a weekly newsletter, Foreign Currency Trends, for Charles Schwab's Global Investment department.

See the full archive of Gary Dorsch.


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