Inflation Triangle Dilemma: Dollar / Oil / Euro 13 comments
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Looking at the world from a detached perspective, it’s not difficult to see that world leaders are in a bit of a dilemma. Well, actually huge dilemma.
Let’s start with Europe, thanks to rising oil and food costs, inflation is rising fast in the Eurozone. To combat this inflation, ECB president Trichet said they may raise interest rates next month. His comments inevitably pushed the Euro higher, and a stronger Euro isn’t welcomed by Trichet and many other European companies and politicians since a higher Euro means the US dollar will have to go down further.
The big problem with a weak dollar is that it is somehow correlated to the rising oil prices as oil is priced in US dollars, and when oil prices are higher, food prices go up too, and you get higher overall inflation whether in the US or in Europe.
So by trying to fight inflation through higher interest rates, Trichet’s actions would incidentally lead to further inflation. Another thing that would give Trichet sleepless nights is that while he doesn’t want Euro to bear the brunt of dollar weakness, it is precisely a strong Euro that is helping to ease some of the inflationary pressures in the Eurozone.
Now let’s have a look at the US: Inflation is skyrocketing and the jump in the May unemployment rate was the biggest in 22 years. Because of the terrible jobs data released Friday, the dollar fell sharply against other major currencies like the Euro and Swiss franc.
Nudged by the dollar’s fall on Friday, oil skyrocketed by over $11 in one day to a new record high of $138.54 a barrel. This will lead to further inflation in the US, and this inflation will harm the economy and the labor market even more, which will limit the Fed’s option of raising interest rates to fight the inflation. If the Fed can’t raise interest rates and the economy is so bad, then the dollar will continue to fall, and commodity prices will continue to rise, and thus goes the vicious cycle.
Of course there are other factors why oil is heading up: Iran-Israel tensions, Morgan Stanley’s prediction of $150 oil in July, surging demand, speculation etc, but that is outside the scope of this post. US stock markets closed down for the week: the Dow was down almost 430 points, or 3.4%; S&P 500 was down 2.8% and Nasdaq closed nearly 2% down. Dismal returns from stock markets? No problem, you can invest in long-only commodity indices to take advantage of the oil bull run, the commodity investment salesperson will say. And when money gets channeled into these funds, you get a continuation of the uptrend.
What Fed chairman Bernanke said: Fed is “attentive to the implications of changes in the value of the dollar for inflation and inflation expectations”.
What Bernanke wants: It’s possibly time for the dollar to be stronger now so that oil can go down.
What Trichet said: The Governing Council is “in a state of heightened alertness” and a small rate increase next month “is possible but not certain”.
What Trichet wants: He needs to raise interest rates soon and doesn’t want the Euro to be so high versus the dollar.
What will happen now: Traders are likely to buy EUR/USD, bidding up the Euro exchange rate, which will pull the dollar down, and cause inflation headaches for the US, Europe and everywhere else in the world. Headache for Bernanke, migraine for Trichet, less purchasing power of the dollar in your purse.
Monday:
German trade balance 0600 GMT
Japan Eco Watchers survey 0700 GMT
UK PPI 0830 GMT
Canada housing starts 1215 GMT
US pending home sales 1400 GMT
Fed’s Geithner speaks about economy 1615 GMT
UK RICS house price 2301 GMT
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This article has 13 comments:
"The big problem with a weak dollar is that it is somehow correlated to the rising oil prices"
Somehow? That's like saying that overdoses are "somehow" correlated with drug use.
Also, there seems to be a problem with your reasoning with respect to the "triangle" premise of this article. Would anyone care to point it out?
You state the totally obvious.
Gives us rather a hint where the dollar will trade next .....and oil, let's hear your opinion .......not just giving us a copy/paste
Anyway, nice article. Triangle is exactly right. Why Tricky can't hold steady and let the differential tighten, or at least stay constant, is beyond me. I'm sure Bernanke would love to raise rates to catch up and is looking for any sign of strength to do so, but the frog wants to play tough guy, I guess.
Trichet and ECB have inflation because they also have been devaluing their currency, preferring liquidity injections. When money is printed faster than GDP growth each unit becomes worth less against commodities with intrinsic value, like oil, gold, or wheat.
As for Bernanke, eventually he might realize that inflation is what is weakening the economy, distorting the normal balance of consumer spending by energy and food taking more than their normal share, causing other sectors to have less available. A couple of quick 25 bp rate hikes, to partially undo the erroneous 75 bp cut after the Asian meltdown, would drop oil to $100 and provide a $160 billion annual stimulus to other sectors of the economy without raising deficit and debt and while lowering trade deficit.
For this week, things will be simple. News that increases the liklihood of FOMC cutting rates will sink the Dollar and sppike commodities; news that makes it less likely that the FOMC will cut rates will keep things flat; news that makes it likely FOMC will raise rates will strengthen the Dollar and lower commodity costs. With faithbased fiat currencies the high priest, Gentle Ben, is also the prophet.
theinvestingspeculator...
When oil gets too expensive, the combination of increased production and reduced demand will bring it back out of the stratosphere. This will happen very quickly once the traders see that the upside potential is smaller than the downside. Ahmedinijad's grip in Iran is not terribly strong and once he is gone his yo-yo-like manipulation of oil prices will fade. Other crises will come and go but that has been the case in the Middle East for the better part of a century. There is talk of reducing government energy subsidies for consumers in Asia. Reduced consumption caused by even a modest slow-down in China/India would take significant wind from the speculator's sails.
Once the oil bubble breaks, it is likely to stay broken for some time. The high price now is stimulating oil exporters to spend lavishly. In other words, they are becoming accustomed to big incomes. When the price falls, they will have no choice but to pump more to maintain the spending levels to which they are becoming accustomed. OPEC members will bicker back and forth over who is over-pumping. We have seen this before.
Market forces will likewise find the appropriate value relationship of the Dollar/Euro. The long-term fundamentals underpinning the Euro are weak relative to those supporting the Dollar. The inherent strength of the U.S. system relative to that of continental Europe makes Euros a long-term loser, despite the near term support afforded by a weak dollar. Certain EU member nations are in no position to weather higher interest rates. Fissures will erupt, putting the unified currency and the member governments under pressure. The relative strength of the well-integrated U.S. economy will lend strength to the dollar, mitigating somewhat the effects of oil prices and interest rates.