Market Watch: US Inflation and Growth Disconnect

In recent days we have seen oil hit $102 a barrel or 100% higher than what it traded at this time last year, gold hit a record $964 an ounce Wednesday and copper rose to $387 a pound, up close to 30% this year alone. At the same time the US dollar index has hit a record low of 74.30, down almost 11% from the same time last year. One might legitimately ask why oil is twice the price it was last year if the world is gripped by an economic slowdown and why are copper prices shooting through the roof when new home sales in the US are at a 2-decade low? The US economy grew a paltry 0.6% year-on-year in quarter 4 and is probably close to negative growth this quarter, yet US headline inflation is running at 4.3% and yesterday US producer prices recorded their highest year-on-year increase since 1981. Normally if the economy slows, prices cool and inflation should soften. So what’s so different now?

1) Investors believe the global economy is sufficiently decoupled from the US economy that economic growth can prosper in Europe, Asia and the emerging economies, even in the face of a US recession. Investors have poured masses of speculative funds into hard and soft commodities which sent the prices of base metals, energy and food soaring over recent months, fuelling inflation.

2) The US Federal Reserve is largely acting in isolation in its aggressive attempts to ease credit tightening and stimulate economic growth. The resultant shift in interest rate differentials between the US and in particular Europe has seen the dollar plummet, meaning the cost of US imports has surged, pushing US domestic inflation higher.

3) Monetary policy easing (cutting interest rates) has the effect of stoking inflation and it is noticeable that the sharp run-up in commodity prices over the past 6 months has coincided with a new cycle of monetary easing on the part of the Fed.

4) There is no evidence yet of dampening demand in the US for oil or for food commodities despite the sharp increase in prices. The market seems determined to push prices to breaking point limit. The relationship between supply and demand has little bearing in establishing an equilibrium price in today’s commodity market. In the short to medium term, commodity prices are being driven by speculative interests.

What’s next?
1) Stagflation. The US is currently in a period of zero growth and increasing prices. The most worrying aspect is that this stagflation is widening - inflation continues to rise and growth stagnates. It could be the second half of this year before the US can breathe again. A ‘decoupled’ global economy would make it more difficult for the US economy to recover, because this would keep commodity prices elevated and make it more difficult for the Fed to cut interest rates further. In a decoupled scenario, were the Fed to ignore price stability and continue to cut rates, it could tip the economy over a more precarious edge.

2) The euro. US inflation is being driven by a weak dollar and unless the greenback stabilises or strengthens against the euro, this situation is likely to get worse. The ECB’s view of the world is different to that of the Fed and the ECB is against cutting interest rates in the current environment. As long as the euro is appreciating against the dollar, investors will feel justified in pouring more speculative funds into commodities, thus pushing up the dollar price of oil, copper, corn etc. and forcing higher inflation, particularly in the US. We are close to the point where direct market intervention on the part of Central Banks to prop up the dollar is close to being on the agenda. The level of dollar depreciation seen in recent days is not sustainable in the longer run and while the sell-off continues, the disproportionate rise in commodity prices is compounding the inflation risks in every major economy, not just the US.

3) The flu. The decoupling theory may not hold true and it may well be the case that the US is simply at the front-end of a severe global-wide economic slowdown. There is plenty of soft data emanating from Europe, the UK and Japan to back up this theory. The US has sneezed and while officials elsewhere have been slow to react, it is only a matter of time before we see a sharper deterioration in the health of other major economies. This will cause a serious rethink and lead to a cooling in commodity prices, which will ease US inflation. In this situation look for a strong bounce in the dollar.

Ted B - Feb 27