Fed Rate cuts Back-fire, Lead to Quagmire of "Stagflation"

By: Gary Dorsch | Thu, Mar 6, 2008
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"Too much money, chasing too few commodities," might be the best way to explain the historic rally that has lifted the Dow Jones AIG Commodity Index into the stratosphere. Central bankers in 18 of the top-20 economies in the world have been expanding their money supplies at double digit rates for the past several years, trying to prevent their currencies from rising too quickly against the terminally ill US dollar.

In response, fund managers have turned to commodities, as a hedge against the explosive growth of the world's money supply, competitive currency devaluations, escalating inflation, and the negative interest rates engineered by central banks. To the chagrin of central bankers, much of explosive money supply growth is flowing into the commodities markets, and elevating inflation rates to multi-decade highs.

The Federal Reserve is the chief culprit behind the explosion in global commodity prices, slashing its federal funds rate at a frenzied pace, to arrest a year long slide in US home prices, which if left unchecked, threatens to topple the US economy into a severe recession. Nearly 8.8 million US homeowners hold mortgages that are larger than the value of their homes, providing an incentive to abandon houses bought on speculation. And according to the Mortgage Bankers Association, the delinquency rate for 3.6 million sub-prime mortgage loans was 17.3% in the fourth quarter.

Wall Street is worried that foreclosures and delinquencies will escalate when many sub-prime loans face built-in interest rate resets that could lift borrowing rates as much as 3% higher in coming months. The worst payment problems have been among sub-prime adjustable-rate mortgages, and more than one-fifth of these outstanding loans were seriously delinquent at the end of 2007.

But as the Bernanke Fed slashes interest rates to stop a slide in the US housing and stock markets, and expands the MZM money supply, at a hyper-inflation rate of +15.7%, it's also simultaneously blowing enormous bubbles in the precious metals and commodities markets. The surge in agricultural and energy prices have led to a +7.5% jump in US producer prices, the biggest 12-month gain in 27-years, and consumer prices are up +4.3%, a 17-year high.

However, "In my view, the adverse dynamics of the financial markets and the economy present the greater threat to economic welfare in the United States. Policy-makers must take into account the possibility of very unfavorable developments," said Fed deputy Donald Kohn on Feb 26th. "We have the tools. As Chairman Bernanke often emphasizes, we will do what is needed!!" Kohn warned.

Such tools include driving the federal funds rate to zero percent if necessary, pumping the MZM money supply growth to above 20%, or buying long dated Treasury securities with printed money. So far, the Bernanke Fed's aggressive rate cuts have done more harm than good for the US economy, leaving the US consumer with slumping home prices on the one hand, and soaring food and energy prices on the other hand, caught in the "Stagflation" trap.

Such reckless policies could also unleash hyper-inflation in the US economy, and trigger capital flight from the US dollar. On Dec 27, China's powerful FX chief, Hu Xiaolin warned, "If the US federal funds rate continues to fall, this will certainly have a harmful effect on the US dollar exchange rate and the international currency system," Hu warned. China's foreign exchange reserves jumped $61.6 billion in January to reach $1.59 trillion in January, after growing $462 billion last year.

Yet even with crude oil closing at a record high of $104.50 /barrel on March 5th, and gold trading near $1,000 /oz, Cleveland Fed chief Sandra Pianalto, said the Fed should continue to err on the side of easing. "Because credit contractions can emerge and spread rather quickly, the central bank must be prepared to act in an aggressive and timely manner to counteract their effects," she explained. The Fed has room to maneuver, because, "Inflation expectations appear to be anchored," she added.

Foreign Central Banks decline to Follow the Fed

However, most other central bankers are not willing to follow the Fed's strategy of hyper-inflating the money supply, despite the extraordinary risks associated with deteriorating credit conditions in the global banking system. Banks and brokers world-wide could recognize more than $500 billion in losses from toxic sub-prime US mortgage debt in the year ahead, blowing big craters into their balance sheets, that won't be plugged by sovereign wealth funds from the Middle East and Asia.

Yet central banks from Brazil, the Euro zone, England, Korea, Japan, and New Zealand left their lending rates unchanged this week, while the Australian central bank hiked its cash rate a quarter-point to 7.25%, a 12-year high. The People's Bank of China drained a net 226 billion yuan ($32 billion) from the Shanghai money markets this week, after it drained a net 164 billion yuan ($23 billion) last week.

Earlier today, the Euro soared to a new all-time high of $1.5370, as interest rate differentials continue to move in the Euro's favor over the terminally ill US-dollar. Tough anti-inflation rhetoric from European Central Bank chief Jean "Tricky" Trichet snuffed out expectations for a Euro zone rate cut anytime soon. "The ECB is strongly committed to preventing second round effects and the materialization of upside risks to price stability over the medium term," Trichet declared.

Apparently, the ECB is guiding the Euro higher to help offset some of the surge in energy and food price-fuelled inflation, despite the potential hit to Euro zone exports. Contrast that with the Fed, which has already slashed rates 225 basis points and is constantly trying to brainwash the American public and global traders into believing the fairy tale that "Inflation expectations are well anchored."

As the marketplace continues to lose faith in the Fed's anti-inflation credibility, it will complicate the central bank's ability to put a safety net under the stock market. "Any tendency of inflation expectations to become unhinged, or the Fed's inflation-fighting credibility to be eroded could greatly complicate the flexibility of the Fed to counter shortfalls of growth in the future," Bernanke admitted on Feb 28th.

In a world of fiat (paper) currency, the full faith and trust in a nation's currency often lies in the policy actions and honesty of its central bankers. Under the Bernanke Fed, global confidence in the US dollar is being torn apart, and the Fed rookies hand picked by Mr Bush, are not telling the public the truth about the inflationary consequences of their actions. The Bernanke Fed is playing Russian roulette with the greenback, and a speculative run on the dollar is now in motion. Yet the Fed's propaganda machine remains defiant, "I don't think that foreign investors have lost confidence in the United States by any means," Bernanke told the Senate on Feb 28th.

Fed rate cuts Lift Crude oil above $100 /barrel

Expectations of a 0.50% Fed rate cut to 2.50% on March 18th has already greased the skids under the US dollar, and convinced speculators to bid crude oil to $105 /barrel. The OPEC-10 cartel wants to be compensated for a weaker US$ with higher oil prices, and held its oil output quotas steady at 27.2 million bpd, insisting oil markets are well supplied and blamed record prices on factors outside its control.

OPEC chief Chakib Khelil said the Federal Reserve, not OPEC, is to blame for high prices. "The US slowdown and lower interest rates have lowered the value of the dollar, and encouraged speculative flows into oil and other dollar-denominated commodities. What's happening in the oil market is due to the mismanagement of the US economy, which is affecting the rest of the world," Khelil told a news conference.

Saudi oil chief Ali al-Naimi noted on March 4th, the growing influence of financial traders who have ploughed $200 billion into oil and commodity markets as a hedge against inflation and the weakening US dollar. "The current oil price has no relation to market fundamentals. It is linked to oil futures, which are witnessing tremendous speculation. There are even those who buy futures and speculate that oil prices will reach more than $200 in 2013," he told the London-based daily al-Hayat.

Right now, futures traders are debating whether the Fed will slash the fed funds rate by a half-point or 0.75% on March 18th, but in either case, the US$ index could be stripped of its life support, and left sliding into a bottomless pit, which in turn, could lift crude oil higher in the weeks ahead. Worse yet, the US economy imported $330 billion of oil from abroad last year at an average price of $64 /barrel. If the US is forced to pay an average $100 /barrel this year, it could boost the import bill by $175 billion, and completely wipe out Washington's $152 economic stimulus package.

Gold set a historic high near $1,000 an ounce and silver jumped to a 27-year peak, as a record low dollar and soaring oil triggered a fresh wave of bullion buying. Spot gold rose as high as $991.80 an ounce before slipping to a low of $960 /oz. Europe's wealthiest families are planning to shift more of their investments further away from stocks and bonds and into alternatives such as hedge funds and commodities.

While gold's spectacular rally against the pathetic US dollar usually gets most of the world's attention, the yellow metal has also soared by 20% against the Euro, from four months ago. The Euro M3 money supply is expanding at a +11.5% annual rate, or three times faster than the ECB's original target, which was deemed consistent with low inflation. The ECB hasn't met its 2% inflation target for the past six years, and inflation is now 3.2% higher from a year ago, a 16-year high, according to calculations that have been heavily doctored by apparatchniks at Eurostat.

But gold's rally against the Euro has become more restrained, as Euro Libor futures contracts begin to slide in Frankfurt, and wipe out any hope of an ECB rate cut for the first half of 2008. On Feb 14th, Bundesbank chief Axel Weber warned, "current interest rate expectations on financial markets do not reflect an appropriate assessment of the inflation risks, at least for a stability-oriented central banker."

For now, the ECB wants to see if a steady repo rate at 4% can block gold's advance at 650 euros /oz. But with the Fed determined to slash its federal funds rate in the months ahead, regardless of the inflationary consequences, and other foreign central bankers unwilling to tag along, the stage is set for extreme volatility in exchange rates, which in turn, can trigger wild gyrations in the commodities markets.

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Gary Dorsch

Author: Gary Dorsch

Gary Dorsch

Gary Dorsch

Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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