Prague Twin

Friday, February 23, 2007

A Funny Thing Happened to the Economy

Currently, most indications are of a strong economy in the U.S. Employment is nearly full, the Equity Markets continue to rise (although a pause seems to be in place for now) and inflation seems to be contained despite very low interest rates.

I can't help but to think that we are getting just a little bit over extended. Recently, there has been some worrisome data on industrial production which has even very unbiased economists muttering recession or even stagflation around the corner. Q4 GDP advance estimate was 3.5% growth, quite healthy. However, Bernanke warned recently that that number would likely be revised down. The consensus for the preliminary Q4 GDP report (to be released next Tuesday) is for a mere 2.3% growth.

Meanwhile, the Consumer Price Index (CPI), one of the most watched and broadest measures of inflation, surprised everyone with a month on month core (core being stripped of volatile food and energy prices) reading of .3% when most people were expecting a flat reading of 0. Education, tobacco, and health care led the charge for the recent gains. So quitely, all expectations for an interest rate cut have disappeared (as I expected) and now the question is, "when will the Fed raise again?" I have been casting doubt on the probablility of a rate cut since last summer in my comment sections (sorry, I'm not going to find the link) but in November I made it clear that I was not in agreement with market expectatons...

Put simply, despite evidence of a slowing economy and a weakening housing market, the Fed will be unable to reduce lending rates, as the market expects it to, due to inflation pressures. As it becomes clear that the Fed will not cut rates, there will be serious fallout for the equities market and the housing industry. Both the Fed futures market and the Bond market expect a rate cut, and in fact more than one. I can't imagine that I am smarter that the market, but I just don't see how the Fed can justify a rate cut until inflation pressures start to ease.

So here we are months later, and despite the realization that the Fed will not cut rates, the Dow is holding steady above 12,600 at least for now. While existing home sales are expected to start a modest rebound (Tuesday) new housing starts and permits are still way off and a further decline in new homes sales is expected on Wednesday. This indicates that we have not seen the bottom of the real estate undwinding.

Add to that the near collapse of the auto industry and it is no surprise that some people are talking about a recession.

But don't expect the Fed to do anything to try to stop it. Inflation will allow them to keep rates on hold at best.

The dollar is on it's heals from a series of small factors. Jitters over a possible conflict with Iran, worry about the fallout from the sub-prime loans (especially now that rate cuts look unlikely), and higher energy prices that will extend the trade deficit have combined to push the EUR/USD to 1.3190. Dealers look for a break of the 1.32 level to make a stronger move against the dollar. The BOE is selling pounds for dollars to try to stop the bloodletting. Only six hours until the close for the weekend. Will the dollar hang on?

The dollar hung on and closed at 1.3164 to the Euro. Have a nice weekend.


  • Heh, I remember when the Euro first came out while I was stationed in Germany...the exchange rate was 93ยข for each Euro.

    By Blogger Frederick, at 4:04 PM  

  • I remeber when the ECB was trying to prop up the Euro at around 87cents.

    By Blogger Praguetwin, at 7:28 PM  

  • If you were in the US you would pretty well think that there is a lot of unmeasured inflation happening here--it doesn't show up in the numbers, but it sure shows up in the pocketbook. Part of this may be retail consolidation in my metro area resulting in higher prices. Certainly the increases in the price of gasoline has affected prices, most definately. Nevertheless, on the ground it still seems as if we have too much money chasing goods.

    Meanwhile, in the US there has been a steady upward increase in the price of European tourism.

    By Blogger Publia, at 10:41 AM  

  • Inflation is still running at about 3% a year, and that does add up. I think we are starting to see the knock-on effects of higher energy prices that were initially absorbed, but had to be passed on eventually.

    By Blogger Praguetwin, at 4:15 PM  

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