Tuesday, December 22, 2009

New York: Runaway Inflation?

The producer price index for November jumped - Pls see figure 1.0(no picture - can't post due to technical problem). For investors and central bankers, shoud this be very worrying? In normal circumstances, yes. In current economic landscape, it would be a no. Why?

1) It should remove all fears of a deflationary environment unfolding in the US. Secondly, oil price has fallen for many weeks now, relieving the latent inflationary pressures. There are apparently various reasons for this welcomed development, example the fall in oil price. One, the supposedly weaker than expected oil demand from the US. Two, a strengthening US dollar. If these 2 reasons are valid, at this level, there's an apparent contradiction.

2)The USD is strengthening because investors are increasingly convinced that the US economic recovery is real, broadening,deepening and sustainable. If this view is valid, then, it can't be that oil demand is weak. If the oil demand is so weak, then the US economic recovery can't be strong. If the recovery is so weak, then, how can the USD be strengtheing? So, which view is correct?

Looking at the various economic and financial evidences, it would appear that the strengthening USD is the most accurate evidence to rely on. The US economic recovery is certainly gathering momentum, broadening and deepening. The latest monthly job report and the sustained and substansial fall in weekly initial claims are solid evidence of a strong recovery forming in background. Given this evidence, the weakness in oil price is a function of the USD strenghening and not weak oil demand in US economy. The surge in the producer price index is most likely a temporary affair. In addition, the strong USD would also mean that higher producer prices need not be translated into higher retail prices. Consequently the federal reserve still can keep the interest rates where they're for a while longer and has time to decide its next course of action vis-a-vis its interest rate policy.

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