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     Jan 6, 2006
Upswings and downfalls

By Jephraim P Gundzik

Despite rising inflation in the United States, more accommodative monetary policy in the early months of 2006 will accelerate US economic growth. This stronger growth will push international oil prices toward US$100 per barrel by mid-year, causing much higher global inflation and foreign capital flight from the US.

With its credibility diminishing, the US Federal Reserve will be forced to tighten monetary policy dramatically, leading to an

abrupt slowdown in global economic growth in the second half of 2006.

The financial media and the Fed have trumpeted the ability of the US economy to withstand rapidly rising energy prices. The Fedís preferred inflation measure, the core personal consumption expenditure deflator, which excludes food and energy price changes, remained virtually stable throughout 2005 as did other measures of core inflation.

However, broader measures of inflation such as the all-items consumer price index and the producer price index for finished goods are on track to reach 4.3% and 6.2% in 2005 from 2.7% and 4.4%, respectively, in 2004. Consumer price inflation in the US has not been above 4% since 1991 while producer price inflation has not been above 6% since 1980.

After raising interest rates in early December, governors of the US Federal Reserve Board indicated that the pace of US interest-rate hikes would soon slow or stop. According to the Fed, the change is justified by the stability of core inflation measures throughout 2005. One more quarter-point tightening of official interest rates may come this month.

Shortly thereafter, Fed chairman Alan Greenspan will retire in favor of Ben Bernanke. That the change in the Fedís policy stance will correspond with the change in chairmanship is no coincidence. Nor is it a coincidence that these very significant changes at the Fed will occur nine months ahead of what could be crucial mid-term elections in the US.

In these elections, all 435 seats in the House of Representatives, 36 governorships and one-third of the seats in the Senate are up for renewal. Public support for the administration of President George W Bush and his Republican Party is quickly fading as a result of the many improprieties and failures associated with the "war on terror".

It is likely the Fed, under the leadership of Bernanke, a Bush appointee, will suspend its efforts to tighten monetary policy during the first half of 2006 to ensure that US economic growth remains robust, improving the electoral chances of the Republican Party in the mid-term elections.

The result of more accommodative monetary policy will be accelerating US economic growth in the first half of 2006. Accelerating growth is expected to increase US demand for oil. The US is by far the worldís largest oil consumer, using more than 20 million barrels of oil per day. By comparison, the entire European Union consumes about 12 million barrels per day. As US oil demand increases, global oil-supply growth is expected to remain weak. The ratio of oil-producing countries likely to experience continued natural production declines to countries expected to increase oil output in 2006 is about 6:1.

Rising oil-demand growth in the US should propel international oil prices toward $100 per barrel in the first half of 2006. Much higher oil prices will rapidly translate into accelerating US and global non-core inflation. Though core inflation in the US may remain stable, much higher non-core inflation will eventually trigger the flight of foreign capital from US bonds.

As of mid-2005, foreign investors, including foreign central banks, held an estimated $6.6 trillion worth of US bonds and equities, up from less than $4 trillion in mid-2002. About 60% of this money is parked in long-term US Treasury, agency and corporate bonds. The rapid and sustained increase of international oil prices is the main factor behind the growth in foreign holdings of US securities and the external supply of dollars used to purchase these securities.

The risk is high that foreign investors will increasingly question the credibility of the US Federal Reserve as monetary policy becomes more accommodative in the face of rising inflation. The strong advance in gold prices in recent months indicates that the Fedís credibility is already under scrutiny. By the second quarter of 2006, foreign sales of long-term US bonds and the sliding value of the dollar could push market interest rates sharply higher.

Ironically, the Fedís obsession with core inflation will push oil prices up and up. A decline in international oil prices will only come with a sharp reduction in oil demand. This will come when foreign capital flight forces the Fed to aggressively raise official short-term US interest rates, reducing US economic growth to less than 2% in the second half of 2006.

Unfortunately, falling international oil prices could be much more problematic for the US economy than rising prices. A sharp decline of international oil prices will deflate the external supply of dollars that has fed foreign investment in US bonds. Oil exporters will have fewer dollars to invest in US bonds. More important, oil importers will need fewer dollars to finance oil purchases, adding to upward pressure on long-term US interest rates and downward pressure on the dollar. The probability that global economic growth will decline sharply is much greater than the probability that it will accelerate in 2006.

Jephraim P Gundzik is president of Condor Advisers, Inc. Condor Advisers provides country risk analysis to individuals and institutions globally.

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Bernanke and the hyperinflation fear (Dec 21, '05)

The decline of the US economy (Dec 17, '05)

Globalization and the dollar (Nov 12, '05)



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