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3 RISKY
BUSINESS Global economy faces a dangerous
year By Jephraim P Gundzik
Rising inflation and falling home prices
are likely to push the US economy into recession
by the second half of 2007. Gathering economic
weakness, combined with negative real yields on US
Treasury securities and growing political pressure
to weaken the dollar will lead to significant
dollar depreciation against most currencies.
Economic growth in Asia, Europe and Latin
America will also weaken in 2007. Slowing global
economic growth will be very bad
news
for equity markets around the world. Dollar
depreciation and rising international energy and
grain prices will be good news for precious
metals.
Impact of instability on
commodity prices While global geopolitical
instability has ratcheted higher every year since
the terrorist attacks on the US in September 2001,
global asset markets have hardly responded. In
2006, many of the world’s stock markets, including
America's, reached record highs. As geopolitical
instability increases further in 2007 the
probability of major disruptions in energy
supplies will grow.
Instability in the
Middle East and Africa is very likely to increase
in 2007. Intensification of Iraq’s civil war,
conflict between Washington and Tehran, escalating
war between the Israelis and Palestinians, and
growing domestic pressure on Lebanon’s US-backed
government will heighten instability in the Middle
East. This instability will help fuel growing
unrest in Sudan, Chad, Congo and Somalia,
provoking significant military conflicts in
Africa. Afghanistan’s insurgency is also expected
to become more violent, prompting the gradual
withdrawal of NATO forces.
Unprecedented
global geopolitical instability will have its most
obvious impact on international commodity prices.
More frequent energy supply disruptions in the
Middle East and Africa, combined with accelerating
natural oil production declines in the world’s
largest oil fields, will keep crude oil and
natural gas prices buoyant. Slower than
anticipated global economic growth will not push
oil prices lower in 2007.
Production
discipline - much greater than generally
understood - among the world’s major oil exporters
will ensure oil supply growth remains below demand
growth. The continued rise of global energy prices
in 2007, paired with growing demand for renewable
energy, will produce further strong increases in
international grain prices. In 2006, corn and
wheat prices in the US jumped by 70% and 60%
respectively. Much of this jump occurred between
September and December.
Rapid growth of
ethanol production capacity worldwide has
contributed to this leap in corn and wheat prices.
Prices for soybeans and other oilseeds have also
begun to head higher on the back of rapidly
growing global demand for biodiesel fuel. The
substantial increase in petroleum-related energy
prices since 2001 is only one factor behind
growing demand for biofuels. Increasingly
stringent environmental regulations, energy
security concerns and targeted levels for
alternative energy use in many countries is also
driving demand for biofuels.
Inflation
and recession The growing use of corn,
wheat, soybeans and other grains to produce
biofuels is expected to nearly double prices for
these commodities in 2007. In addition to
grain-related foods, prices for other food staples
that are grain-dependent, including meat and milk
products, will also head higher in 2007. The
result will be much higher than expected US
inflation. Consumer price inflation (CPI) in the
US is already significantly higher than CPI in
Germany, Switzerland, the UK and Japan. In 2007,
US inflation will accelerate, widening the
inflation gap between it and other countries.
By every measure, inflation in the US has
clearly accelerated since 2004. In 2005, the
Federal Reserve’s preferred measure of inflation,
the personal consumption expenditure (PCE)
deflator exceeded 2% for the first time since
1995. The core PCE has continued to accelerate in
2006, and will likely top 2.5% by the end of the
year. This is significant because the Fed’s stated
aim is to keep core PCE between 1.5% and 2%. The
steady acceleration of core PCE shows that
inflation from rising energy prices has penetrated
the broader US economy.
Despite the
obvious acceleration of inflation, the Federal
Reserve shifted monetary policy into neutral in
late summer. The Fed has justified more
accommodative monetary policy in the face of
rising inflation by suggesting that slowing US
economic growth will eventually mitigate
inflation. This is a huge gamble because US
inflation is being pushed higher by supply-driven
energy price shocks rather than demand. In 2007,
continued energy supply shocks are likely to feed
a grain supply shock, stoking a sharp increase in
food price inflation and further acceleration of
core PCE.
The stated logic behind the
Fed’s monetary policy change is spurious, to say
the least. A 12-year-old child could grasp the
idea that energy supply problems are pushing US
inflation higher and that these supply problems
are likely to intensify in 2007. This suggests
that another explanation must be behind the Fed’s
shift to more accommodative monetary policy. The
most likely seems to be growing concern among Fed
policymakers over
