Wednesday, June 4, 2008

Raising Interest Rates the Wrong Call.


I have seen and heard a great deal of discussion concerning the need for the Federal Reserve to start aggressively raising interest rates because of inflation. I tried hard to justify in my own mind that thinking and I have concluded that the idea is just wrong. Let me tell you why I think it is wrong.

The two factors that are driving the current inflation problems are food and energy. The culprit is worldwide demand for both of these commodities. There is no question that, as countries accept democracy, and begin to build a market based economies, the demand for food and energy increases.

Keep in mind that the United States Economy is service and consumer based economy. The needs of the American consumers account for about 70% of Gross Domestic Product (GDP). In the past, the driving force behind inflation, in the United States has been dramatic increases in the cost of wages or unit labor costs. For many companies in America, labor is the most expensive item in its cost to produce goods or services. We have not, as of yet, seen any significant increases in unit labor cost.

With that as background, lets again look at the premise that the Fed needs to start increasing interest rates. How would increasing interest rates bring food and fuel inflation under control? Will increasing interest rates in the United State cause the economies of the far east to cut back on their demand for food and energy? The bottom line is they will not. Higher cost to borrow money will not stimulate the expansion of capital to find and fund new energy sources. Higher interest rates will not allow the farmers to put more seed in the ground to grow more grain to feed the world.

No blog post of mine would be complete without some mention of the housing problem. Higher interest rates by the Fed will not stimulate the housing sector into recovery--just the opposite. I saw a report on what has been happening in the worst real estate market in the country, Cape Coral Florida. The reporter stood in a house that sold new in 2005 for $619,000. It is currently under contract for $293,000, a decline of $326,000.

While the street is calling for the Fed to start seriously thinking about raising interest rates in the fall, I think the Fed is sitting back and waiting to see if the price of food and fuel starts to fall back. I suggested in a recent blog that I thought food and fuel were in a bubble state. I was not sure if the bubble would burst or turn into a slow leak. Based on the market action over the last week or so it appears that the slow leak may be gaining some momentum. I stand by my prediction that I think gold will be under $850 by mid summer and WT crude oil will be around $100. If I am right then I think the inflation problem will start to come down and take pressure off the Fed and the markets just in time for the fall election.

Dan Perkins

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