Stocks up big, oil up big, dollar down big, and interest rates lower. How does this happen?

Review

Twin themes remain

• weakness
• inflation

Sources of weakness

1. Shrinking gov budget deficit caused the financial obligations ratio to get too high by Q2 2006 to support the private sector credit growth needed to sustain previous levels of aggregate demand.
2. Subprime business plan failed (mainly due to lender fraud) and removed that bid from the housing market.
3. Lower interest rates reduce personal/household income.

Supporting GDP

1. Exports booming due to a reduced desire of non residents to accumulate $US financial assets. (This drives the $US down to levels where non residents are spending them on US goods and services.)
   1. Paulson branding any country that buys $ a ‘currency manipulator’
   2. Apparent lack of Fed concern about inflation discouraging holders of $US financial assets
   3. Bush policies discouraging ‘less then friendly’ oil producers from accumulating $US financial assets
2. Govt. spending moved forward from 07 to 08 now kicking in.
3. Fiscal package begins to distribute funds in May.
4. Pension funds adding to allocations for passive commodity strategies

Sources of Inflation

1. Sufficient demand for Saudis/Russians to act as swing producers and set crude prices as high as they want to
2. Biofuels linking energy prices to food prices as we burn up the world’s food supply for fuel
3. Govt. payrolls and transfer payments indexed to CPI
4. Weak $US policies driving higher import and export prices
5. Pension funds adding to allocations for passive commodity strategies
6. Pension funds contributing to the $ decline by allocating funds away from domestic equities to foreign equities
7. Sovereign wealth funds allocating to passive commodity strategies

An export economy looks like this

1. Weak domestic demand and domestic consumption
2. Exports strong enough to sustain reasonable levels of employment (but generally not full employment)
3. Employment and output stays reasonably high.
4. Domestic prices are high enough relative to domestic wages to subdue domestic consumption.
5. Foreigners ‘outbid’ domestics for the remaining output that thereby gets exported.
6. The domestic economy works more and consumes less (lower standard of living), with the difference accounted for as ‘rising savings.’

Mainstream history (not mine) will show the following errors made by the Fed

1. They ‘paused’ a couple of years ago as the great commodity boom was hitting it’s stride, monetizing (whatever that is) the price increases, and allowing a relative value story to turn into an inflation story.
2. They cut aggressively into a triple negative supply shock exacerbating the monetization (whatever that is) process due to the following fundamental errors of judgement:
   1. They read futures prices in food and energy as ‘expectations’ of lower prices in the future, rather than as indicators of current inventory conditions.
   2. They assumed gold standard tail risks to a non convertible currency regime.
   3. They failed to recognize the source of rising crude prices was foreign monopoly pricing.
   4. They delayed introducing the TAF for several months.
   5. They pushed the President and Congress into increasing the budget deficit with an inflationary cash give handout.
3. Failure to recognize the influence of pension funds on inflation and aggregate demand
4. Failed to understand reserve accounting and liquidity issues
   1. Thought open market operations altered functional quantitative measures, not just interest rates
   2. Delayed implementing the TAF for several months to accept additional bank assets as collateral
   3. Failed to recognize that the liability side of Fed member banks is not an appropriate source of market discipline

Back to the present

• Stocks are up as financial risks ease with the monolines sorting things out, and energy and export businesses boom.
• Stocks are up as markets believe the Fed doesn’t care about inflation and will leave rates low for an extended period of time.
• Crude is up as Saudis/Russians continue to hike prices.
• The falling dollar results in higher import prices including gold, silver, copper, and most everything else.

Interest rates are down as markets read the Kohn speech as saying the Fed expects inflation to come down so there’s no need to be concerned or take action. And inflation is a lagging indicator that historically comes down after the Fed cuts rates when the economy weakens.