ECONOMIC
FORECAST, 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
Fed’s 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 Fed’s 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 world’s 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
Fed’s 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 Fed’s 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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