Inflation up - wages down - markets rollercoasting - problems mounting

Wednesday, April 20, 2005

Despite some positive surprises in corporate profits in the first quarter the problems for the American economy are mounting. Two weeks before the next FOMC meeting of the Federal Reserve US consumers got shot twice in their check-writing hand. Not only did prices rise 0. 6 percent in March vs. February which is the strongest advance since April 1999. Their pain gets aggravated by a real decrease of average wages at a monthly rate of minus 0.3 percent, leaving them with 0.9 percent less money in their pockets to spend.
Stock and bond markets went on a rollercoaster, pushed up and down between joy about solid corporate profit growth and fear about the acceleration of the inflation rate. US consumers account for 75 percent of economic activity.
Combine this with a new upturn of oil prices, the dramatic decline of housing starts reported the day before and no signs that the government is slowing its spending and not only the Prudent Investor comes the conclusion that the surfacing iceberg of problems could easily become too massive to be kept under control by the rate setting hand of the Federal Reserve.
Previous leaders have already voiced their concerns about the now rapidly unfolding events. Former "King of Wall Street" John Gutfreund said last Friday that "the US has been printing a lot of dollars recently" and criticized the Fed for raising rates "belatedly" in a Bloomberg TV-interview.
Greenspan's predecessor as head of the Fed, Paul Volcker, voiced his concerns in a contribution to the Washington Post. To quote Volcker, "I don't know of any country that has managed to consume and invest 6 percent more than it produces for long. The United States is absorbing about 80 percent of the net flow of international capital. And at some point, both central banks and private institutions will have their fill of dollars. I don't know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change".
Volcker steered the American economy through its highest postwar inflation period in 1980 by raising interest rates aggressively, withstanding criticism that he would suffocate the economy. Listening, but not adhering to the wishes of politicians and business captains who will always vote for low interest rates, he managed to overcome the confidence crisis in the US and its currency within a difficult four year period. Volcker raised the Fed fund rate from 10.1 percent in Jan 1979 to a record high of 19.1 percent within 24 months, seeing the economy contracting every third quarter. His firm stance helped. Once Fed funds went back into the single digit range in October 1982, the economy went on a path of steady expansion again.
In hindsight Volcker was very successful by laying the base for the longest upturn of the stockmarket that began in 1982 and lasted until 2001. He hammered down annual inflation from a record high at 16.8 percent in January 1980 to a mere 2.4 percent in December 1986.
Today the Fed funds rate stands at a mere 2.75 percent while the annual inflation rate for March came in higher again at 2.6 percent. Producer prices accelerated ever faster since January too.
Lots of worrying data on Greenspan's desk
Alan Greenspan, giving testimony to the US senate on Thursday 16:00 CET about "budget process reforms", has indeed a lot of worrying data on his table to scratch his head about the short term course of interest rate policy.
If the FOMC rises interest rates too fast to avert a decline of the dollar, it will hurt the fragile economic expansion which is largely based on the growing use of home equity as consumers mortgage their property to ever higher levels. See the Prudent Bear chart library for evidence. If they continue the "measured" 25 basis point hikes the Fed might see its key interest rate lag behind the accelerating trend in inflation that could lead to the feared stampede out of the dollar.
Markets meanwhile see a flight to quality - real quality. Gold and silver have been inching up more than 3 percent over the last four trading days, easily outpacing any other paper asset class. So far there has not been a single period of rising interest rates that did not send stocks lower overall.


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