Inflation Triangle Dilemma: Dollar / Oil / Euro

Includes: DBO, ERO, EU, OIL, UDN, USO, UUP
by: Grace Cheng

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.


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