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Sy Harding asked:


Oil and gold prices declined sharply mid-week this week, raising some excitement for a few days that maybe the back of inflation has been broken.

Yet, the previous week the Fed raised its forecast for U.S. inflation this year to a range of 3.1% to 3.4%, a full percentage point above its previous forecast of 2.1% to 2.4% (which was already above the upper limit of its ‘comfort zone’ of 1.5% to 2.0%).

U.S. consumers may think that even the Fed’s new numbers are unrealistically low, given that oil, gasoline, and the cost of many food items, have increased 50% to 70% over the last year or so.

If the government’s numbers are correct, the U.S. is certainly fortunate compared to much of the rest of the world. Inflation in China, India, Indonesia, and Saudi Arabia is running at more than 8% annually. Russia reports its inflation rate has surged to 14%. Some South American countries have it much worse. Argentina’s inflation rate is more than 20%, Venezuela’s almost 30%. The European Central Bank estimates average annual global inflation has risen to 5.5%.

But shouldn’t inflation be declining?

A slowing economy usually pounds inflation down significantly. And in the U.S. the economy has already slowed, and looks to slow further. Last week the Fed significantly lowered its forecast for economic growth to a range of just 0.3% to 1.2%. Some economists are predicting it will slow all the way into recession. European economies are also beginning to slow.

A slowing economy not only slows overall inflation but makes it difficult for a more serious wage-price inflation spiral to get a foothold. Wage-price inflation begins when higher prices are followed by demands for higher wages to meet the increased cost of living, the higher wages resulting in still higher prices for products, so more demands for higher wages, until it spirals out of control. But in a slowing economy workers are more worried about losing their jobs, which makes it difficult to demand higher wages in spite of the rising cost of living.

However, there has been a significant difference in this cycle. The U.S. no longer dominates as it did a decade or two ago. Emerging countries have become a much larger part of the global economy. Their economies remain vibrant, producing at near full capacity, some even experiencing a shortage of workers. Wage-price inflation is already creating higher inflation rates for many of them, putting upward pressure on global inflation as the prices of their exports increase.

So what can be done about it?

Since inflation is usually caused by an overheated economy and easy money (too much money chasing too few products), central banks usually try to ward off rising inflation by raising interest rates.

However, in this cycle it has been difficult for the U.S. and European countries to do so. In fact, in an effort to prevent the slowing U.S. economy from falling all the way into recession, the Fed has had to go the other way, cutting interest rates aggressively since last September.

At the same time, emerging countries have been reluctant to raise interest rates, not really wanting to slow their strong economies. Instead they are making the same mistakes the U.S. made in the 1970s, trying to control their inflation problems through price controls, which as the U.S. proved then, do not work.

So, with the price of oil providing the most obvious evidence of global inflation, stock markets were relieved to see oil prices decline sharply for a few days this week, raising hope that the back of inflation has been broken.

But the hope is premature.

Having spiked up to a new record high above $135 a barrel the previous week, becoming short-term overbought in the process, oil had pulled back to as low as $126 a barrel by Thursday of this week. And that was encouraging?

Four weeks ago, when oil was scaring everyone with its rise to $112 a barrel, the thought of being encouraged by $126 oil would have been ridiculous. But after first surging up to $135 the previous week, then sliding back to $126, the picture seemed different. It had some analysts quite relieved, convinced that inflation pressures are behind us.

Gold, that age-old predictor of inflation, also encouraged the thought that the back of inflation had been broken this week. Since correcting back to $850 an ounce three weeks ago, gold had spiked back up to $928 an ounce, which had it also short-term overbought, and probably due for a brief pull back. So when gold also declined sharply for three days, along with oil, it was doubly convincing to some that inflation might be on its way into history.

However, three days does not establish a trend. And sure enough, gold also halted its decline, to close up $10 an ounce on Friday.

So, I’m afraid that nothing had changed in global conditions in those three days mid-week to change the Fed’s forecast of higher inflation ahead, or my concern that continuing easy money policies provide little promise that inflation will be put back in the bottle any time soon.

Bonds seemed to recognize that better than most markets, closing down quite sharply, almost 2%, for the week, on concerns that the Fed will have to begin raising interest rates soon if it is to stand any chance at all against inflation.

 

Sy Harding publishes the financial website www.StreetSmartReport.com and a free daily Internet blog at www.SyHardingblog.com. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beating the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!