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The Producer Price Index Pops...Will The Federal Reserve Play Ball Or Drop The Ball?

|Includes: AAPL, GS, JPM, Exxon Mobil Corporation (XOM)

The Producer Price Index (PPI) showed a stronger than expected increase which tells of inflation pressures on the producer side of goods.  Later this week we will get the Consumer Price Index (NYSEARCA:CPI).  With inflation creeping back into the picture, the dollar spiked higher as expectations that the Federal Reserve will have to raise interest rates.  This would help curb inflation pressures in theory.  However, the Federal Reserve has some major problems.  Essentially there is a major black hole and a huge catch 22. If the Federal Reserve does not raise interest rates, inflation may run away and considering we are showing little or no growth in the economy, we could be in the worst possible situation with Stagflation.  Stagflation is when there is inflation and no growth or slowing growth.  This kills the consumer because without growth, wages stay the same yet buying power gets hurt.  Ultimately, it makes the consumer much, much poorer.

Major leading stocks continue to be very weak telling us the internals of the market are not strong.  Apple Inc. (NasdaqGS: AAPL), Goldman Sachs Grp (NYSE: GS), JP Morgan Chase Co. (NYSE: JPM) and even Exxon Mobil CP (NYSE: XOM) are all lower and have been lower a majority of the day.  The market gapped down but then staged an impressive mid morning rally to go to gap fill.  However, these leading stocks told top traders at that the rally would fade.  Sure enough, the markets are hovering back down, just off the lows of the day.  The technology filled Nasdaq is the strongest index of the day, just down fractionally.  The dollar PowerShares DB US Dollar Index Bullish (NYSEArca: UUP) rallied off the PPI data as the squeeze continues on the dollar.  The UUP has major resistance between $23.00 and $23.12 on the charts.  Should that level hit, expect a pullback in the dollar and commodities to get a bid.

So what is keeping the Federal Reserve from raising interest rates then?  There are many answers to that.  First and foremost is political.  There is a lot of pressure on Ben Bernanke to keep interest rates low to help growth come back.  Do not think that President Obama does not have Bernanke on speed dial and even though the Federal Reserve is supposed to be independent, it clearly is not outside the realm of influence by the government.  The second more important issue is what happens to housing if interest rates rise.  Housing is still at the bottom with prices in many areas down more than 50% from the highs.  If you raise interest rates, less people can afford to buy houses and it will start another leg down on housing.  If the housing market does not come back, the economy will not either.  More foreclosures, more short sales, it will continue to spin out of control.

In addition, President Obama has been up in arms over the lack of lending being done by the major banking institutions.  There is one easy way to solve this.  Increase interest rates.  This is so obvious it almost knocks your socks off.  Interest rates are so low there is absolutely no incentive for major banks to lend.  Instead, they can get guaranteed returns from treasuries or other safe investments.  If you were told you could lend to a consumer for 5% and take on a huge risk of default or lend to the government and get a guaranteed return of 3.5%, which would you do?  That small different is not worth the risk.  If you increased interest rates these banks would have a major incentive to lend due to increased profits.

As you can see, there is really no right answer.  It is just a matter of deciding which is the lesser of two evils.  Either way, there are more problems ahead. The Federal Reserve and government are making them last longer as well due to their print trillions of dollars policy.  There is no way this economy does not see massive inflation down the line in 5-10 years.  In the near term, I do believe there will be muted inflation because you still have a deflationary environment due to the housing collapse and the credit crunch.  However, that will not last forever.

The next bubble is in treasuries and the US dollar.  While other countries start to default on loans and debt payments, the US will be immune due to its long lasting safety net it has built.  However, eventually it will become the biggest default in history.

Gareth Soloway
Chief Market Strategist