By Gary Dorsch
In an age where governments of every political stripe distort data to promote their own self interests, it’s hardly surprising that they present inflation data in a manner that is best suited to their particular needs. By the same token, it’s entirely natural for official inflation data to be wildly at odds with the reality that is faced by consumers and businesses, and to be regarded with utter disbelief.

So it wasn’t shocking to hear Federal Reserve officials insist last week, that inflation in the United States is under control, before telegraphing another tidal wave of liquidity injections into the US economy in the months ahead. “Stable inflation expectations give the Fed a lot of room for maneuver. If the evidence suggests that substantial policy easing is appropriate, I don’t think we’re going to face a risk of adverse inflation consequences,” said St Louis Fed chief William Poole on Jan 9th.

In an election year for the highest office in the land, American politicians from both sides of the isle, are quick to propose all kinds of fiscal stimulus and pork barrel projects to jump start the sputtering US economy. But adding more monetary stimulus to the mix has the potential to ignite hyper-inflation in the US economy, and a speculative attack on the US dollar in the $3.2 trillion a day currency market.

“It’s difficult enough to make good policy in a complex economy and complex financial system,” said Fed chief Ben “B-52” Bernanke on January 11th. “Political considerations will play no role, and I assure you as strongly as I can, that we will be objective and analytical, and we’ll do what’s right for the economy,” he said.

It’s now becoming increasing clear, that the only prices the Fed is focusing on these days are home prices and those for toxic sub-prime mortgage debt. The Fed is pegging the federal funds rate in the direction of US home prices, mimicking the Bank of England as an asset targeter. Last week, nearby futures contracts on the Standard & Poor’s/Case-Shiller, an index of home prices in the top-10 US cities, fell below the 206-level, or roughly 7% lower from a year ago.

Robert Shiller, a Yale University economist, and co-founder of the widely watched house-price index, predicted on Dec 31st, a possibility that the US economy would stumble into a Japanese-style recession, with house prices declining for years. “American real estate values have already lost around $1 trillion. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars’ worth of losses.”

He noted that Chicago futures markets are pricing in further declines in US home prices, with farther dated contracts on the S&P Shiller Index pointing to losses of up to 14 percent. In the third quarter of 2007, US homeowners withdrew $20 billion less in equity from their homes than in the prior quarter, and since housing prices have continued to tumble, the outlook for cash-outs has continued to dim.

Lenders have also grown more cautious in handing out cash through home equity lines of credit since those loans were failing at their highest rate in ten years during the third quarter. If the housing market continues to sink this year, consumers will have less home equity to convert into cash, which could lead to a big pullback in spending. With consumers struggling with high energy costs and a softening jobs market, the drying up of home equity could usher in an economic recession.

Slumping home prices and a softer jobs market, could increase foreclosures on many sub-prime home borrowers, and blow huge craters in the balance sheets of banks and brokers worldwide. Credit Suisse projects 775,000 homes with $143 billion of mortgage debt will go into foreclosure in the next two years. Goldman Sachs estimated that losses in mortgage markets worldwide may reach $726 billion.

Some BBB rated sub-prime mortgage bonds have already tumbled to 16-cents on the dollar from 50-cents last July. AA rated paper isn’t faring much better, fetching only 40-cents in the $1.8 trillion sub-prime mortgage market. On January 15th, Citigroup C.n, the nation’s largest bank, took a fourth-quarter loss of nearly $10 billion, stemming largely from $18 billion of write-downs of sub-prime mortgages.

The deepening gloom in the US financial sector came as Bank of America BAC.n agreed to acquire battered mortgage lender Countrywide Financial CFC.n for $4 billion, to avert one of the biggest collapses due to the toxic sub-prime debt bomb. Merrill Lynch is expected to suffer $15 billion in losses stemming from soured mortgage investments, as the sub-prime debt bomb goes nuclear.

Bernanke Signals more Rate cuts in Q’1

With the US economy sinking deeper into the “Stagflation” trap, and credit worries clogging the arteries of the Libor market, Mr Bernanke shouted loud and clear for the whole world to hear on Jan 10th, that the Fed and the US Treasury (the “Plunge Protection Team” - PPT) have decided to exercise the “Greenspan Put” option, and will simply disregard elevated inflationary pressures in the rest of the economy.

“In light of recent changes in the outlook for and the risks to growth, additional policy easing may be necessary,” Bernanke said on January 11th. “We stand ready to take substantive additional action as needed to support growth and to provide adequate insurance against downside risks. Inflation expectations are reasonably well anchored,” and he pledged to monitor inflation expectations closely.

For the PPT, the devil of hyper-inflation is preferable to the specter of a bear market for the Dow Jones Industrials and weaker home prices. Exercising the “Greenspan Put,” means the Fed will slash the federal funds rate far below the US inflation rate in the months ahead. But that’s a frightening prospect for foreign holders of $2.3 trillion of US Treasury debt, who must contend with negative interest rates, which in turn, could severely weaken their US dollar denominated investments.

The Fed is signaling aggressive rate cuts at a dangerous time. Inflationary pressures in the US economy are elevated at multi-decade highs. US producer prices were up +6.3% last year, and US consumer prices up +4.1%, the highest in 17-years, compared with +2.5% for 2006. Gasoline costs were up 37%, and food prices were up 9.3% last year, embedding inflation fears into the American psyche.

Thanks to the Fed’s cheap dollar policy, US import prices rose +10.9% in 2007, the largest calendar-year increase since 1987. The Dow Jones AIG Commodity Index soared to an all-time high of 193.25, exerting upward pressure on raw material costs. Only one lone voice of reason from Foggy Bottom is advising caution. “I would be very careful, not to let inflation accelerate too long,” warned Kansas City Fed chief Thomas Hoenig on January 10th.

But Hoenig was rotated off the Fed’s interest rate setting committee, after he dissented against a rate cut in October, in favor of keeping Fed policy on hold. Instead, the politically correct thing to do in Washington these days is to cut rates and drop dollar bills across America from helicopters and B-52 bombers.

The Fed’s big Gamble

The Fed is betting that a sharp slowdown in the global economy will weaken commodity prices, and that Saudi Arabia will pump more oil, to keep inflationary pressures at bay. Until now, the Fed’s rate cutting campaign, its special $80 billion liquidity injection scheme and promises of another big tidal wave of liquidity, have severely weakened the value of the US dollar, which in turn, fueled parabolic rallies in crude oil and precious metals to all-time highs.

Fed rate cuts also fueled Agri-flation worldwide. In Chicago, March wheat jumped the to $9.40 /bushel, after the USDA reported smaller than expected US plantings for hard red winter wheat. Corn surged to an 11-year high of $5.15 /bushel, on a big drawdown in US corn stocks. July soybeans soared to $13.76 a bushel, buoyed by fears that corn’s surge could cut into soybean plantings for 2008.

Rough rice futures in Chicago hit an all-time high of more than $15 per hundredweight, 37% higher from a year ago. Egypt is a major exporter of rice, but has suspended exports indefinitely, due to hoarding and speculation in its local economy. In Pakistan, armed guards escort trucks carrying high-prized wheat. India will become a net importer of rice this year, for the first time.

Jordan intends to double the stocks of wheat inside its country to 390,000 tons, equivalent to six months of supply, plus a further 130,000 tons purchased and being shipped, representing two months of supply. Doubling wheat stocks is an indication that some major importers see no end to the bull market in Chicago and want to protect themselves. Ocean shipping costs for dry goods have fallen 35% in recent weeks, which may encourage more purchasing of grains.

Bush Seeks Quick Fix to Tame Oil prices

On his arrival in Riyadh on January 15th, President Bush urged Saudi king Abdullah to put more crude oil on the world market, warning that soaring prices could cause an economic slowdown in the United States, and weaken the housing market. “High energy prices can damage consuming economies. When consumers have less purchasing power, it could cause the economy to slow down. I hope OPEC nations put more supply on the market. It would be helpful,” he said.

Saudi Arabia is the only member of OPEC with spare capacity - roughly 2.8 million barrels per day. Saudi Oil chief Ali al-Naimi said on Jan 15th, that Riyadh is ready to boost oil output if the market needed more oil to tame high prices.
“Nobody would look with pleasure on a recession in the United States. Concerns about US economic growth are valid. But the price of oil is more than just the US economy. Global economies are growing despite oil prices ranging between $90 and $100 a barrel,” Naimi said.

For instance, China’s oil imports rose 12% last year to a record 3.26 mil bpd.

But al-Naimi also blamed speculators in London and New York for inflating the price of crude oil by $20 to $30 per barrel. “Twenty to thirty dollars is the outside influence on the price of oil. If you look at who’s in the market, you’ll find a lot financial institutions are speculating, using the market as a hedge.” Still, Naimi wouldn’t say if Riyadh would agree to boost oil output at OPEC’s Feb 1 meeting.

King Abdullah must walk a along a tightrope, balancing his military patron’s request for more oil, against Iran’s opposition to further increases in output, which could hurt Tehran’s oil revenue. On Dec 5th, Iran’s President Mahmoud Ahmadinejad scored a big victory, when he convinced king Abdullah to join the hawks of OPEC – Iran, Libya, and Venezuela, and hold the cartel’s oil output steady at 27.25 million bpd.

“Our position is that demand and supply are balanced and there is no need to increase oil to the market,” said Iranian Oil Minister Gholamhossein Nozari. Still, the key question is which way will Saudi oil policy lean at the upcoming Feb 1st meeting in Vienna, in favor of US Prez Bush or Iran’s Ahmadinejad?

However, Riyadh is keen to keep oil prices elevated within a higher target zone, to sustain the enormous flow of petro-dollars to the Gulf, which has revived the speculative appetite for the local stock market. The Saudi All Share Index hit the psychological 12,000 barrier last week, enriching the brokerage accounts of 7,000 Saudi princes, who control 70% of the market.

Beijing warns US Treasury against further Fed rate cuts

Beijing also finds itself in a tough predicament, with $1.53 trillion of foreign exchange reserves over the past five years, mostly stockpiled in depreciating US dollars. However, Chinese leaders finally woke up to the folly of such a foolish investment policy. “The world’s currency structure has changed,” declared Xu Jian, vice director of the People’s Bank of China (PBoC) on Nov 7th.

“The US dollar is losing its status as the world reserve currency,” he warned. “We will favor stronger currencies over weaker ones, and will readjust accordingly,” added Cheng Siwei, vice chairman of China’s National People’s Congress. On Dec 27th, Hu Xiaolian, director of China’s Foreign Exchange department, wrote, “If the US federal funds rate continues to fall, this will certainly have a harmful effect on the US dollar exchange rate and the international currency system,” he said.

Traders closely watch any change in China’s strategy which could affect exchange rates. China’s central bank is tightening its monetary policy to combat inflation, which is raging ahead at a 6.5% annualized rate. At the same time, the Bernanke Fed is preparing to flood global money markets with another tidal wave of cheaper US$’s. China raised benchmark interest rate six times in 2007, but the benchmark one-year deposit rate of 4.14% is still far lower than the inflation rate.

“We must be sure about one thing, the central bank is moving towards the objective of positive real interest rate instead of moving away from it, “said Yu Yongding, a key advisor to the PBoC, on Janaury 3rd. The next day, the PBoC vowed to further tighten monetary policy in 2008, aiming in particular to prevent inflation from moving from certain sectors to the broader economy.

A year ago, the US Treasury’s 5-year T-note was yielding +2% more than China’s 5-year note. But today, the US T-note yields -1.2% less, putting enormous downward pressure on the US$ /Chinese yuan, and cementing big foreign currency losses in Beijing’s portfolio of US bonds. According to forward traders in Hong Kong, the dollar is expected to fall another 9% to 6.6-yuan over the next 12-months.

Since March 2006, China has been a net seller of US Treasury debt, reducing its exposure from $421 billion to $386.7 billion in November, and seeking to avoid further losses on the dollar’s exchange rate with the yuan. “The weakening dollar and rising global commodity prices is also creating inflationary pressures for China, but a quicker appreciation of the yuan would probably help offset some of those price increases,” said Yao Jingyuan, chief economist of the state statistics agency.
On Jan 16th, the PBOC hiked bank reserve requirements by 0.50% to a record 15%, a move that will drain 200 billion yuan ($28 billion) from the Shanghai money markets. The dollar fell to 7.23 yuan, or -3.2% lower since late October, a faster decline than the -1.2% slide in the US Dollar Index over same period, meaning the yuan is rising at an even faster pace against a basket of six major global currencies, including the Euro, British pound, and Canadian dollar.

Courtesy: www.freebuck.com

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