Recently the bond market has sold off on renewed inflation fears and the stock markets have eased on expectations of slower economic growth. Unfortunately, we agree with both these fears, which amount, as we have warned, to the dreaded virus of stagflation that afflicted us in the 1970s.
This places the Fed in a real fix.
As stated, we see a probable run on the U.S. dollar in 2007, taking center stage, in dictating future Fed rate policy.
Many central banks, corporations and investors are diversifying their cash reserves into the euro, putting downward pressure on the dollar.
In addition, a growing number of oil producing nations (Iran and Venezuela-see more in FIR) are demanding Euros in exclusive payment for their oil.
The Euro is run on Germanic (anti inflationary) lines by the European Central Bank (ECB) which has, unlike the Fed, only a single mandate, to keep inflation at bay. They can therefore be expected to raise Euro rates, even to the detriment of economic growth in the E.U.
The ECB is reported to be likely to raise rates further, putting yet more downward pressure on the dollar.
China (holding some $700 billion in dollar reserves), fears further decline of the dollar, but is willing to bargain its ability to cause a dollar run and possible default, in order to keep American consumer markets open to its cheap products against an antagonistic Democrat-controlled Congress.
We believe that the sum of these factors places the Fed in an unenviable dilemma over interest policy.
As previously reported in this column, we feel that, by leaving rates on hold in the second half of 2006, while inflation appeared to fall by some 30 basis points, the Fed in effect has tightened real interest rates by 0.30%. However, this effect fell below the radar of the mainline media.
What also appears to have escaped media attention is that it is neither inflation nor economic growth that will dictate Fed policy as we move into 2007, but defense of the dollar.
Defense of the dollar is a major shift in policy that is likely to dominate Fed thinking in 2007 and result in an upward bias in interest rates.
We should all feel great sympathy for the Fed Chairman Bernanke when he returns from Christmas to defend the U.S. dollar and at the same time, try to balance the economy.
In the meantime, we take this opportunity to wish all our readers a very happy Christmas.