Zeev's Turnips Patch-No Politics (ZEEV)

[hightecheast]

As some of you know, I follow the world macroeconomic situation every day. And while I do not pretend to know everything there is to know, I do closely study the Financial Times, The Wall Street Journal, Barron’s, The Economist, The New York Times, Stephen Roach of Morgan Stanley, Bill Gross of PIMCO, Jim Fraser of ContraryInvestor,com, Lowry’s, John Murphy’s Market Message, John Mauldin, John Hussman and every meaningful book about investing I can get my hands on. I have proven (at least to myself) over the last number of years that I have a pretty good understanding of what is going on in the world economy, and how the long term consequences and impacts are likely to show themselves to investors. I only wish I could predict the timing of events, but of course, I can not. The only evidence I can offer you that I might know what I am talking about is in my accomplishments … total returns for my family of over 746% in the last eight years and 38.53% for 2004 (through October 31).

I am not trying to sell you anything. The primary benefit of researching, analyzing and then writing about it is that it helps me understand the big picture better so I can make more effective investment decisions for my family.

Kill the Dollar

What I find rather remarkable is that the financial media, the Fed and Wall Street have recently and generally accepted the fact that a significantly lower US Dollar is not only inevitable, but that they are trying to sell this probability as necessary and generally good for America in the long run. While their posturing is often contradictory and confusing, the bottom line is the same, the dollar has much further to fall – especially against Asian currencies.

Of course, they are correct. A lower US Dollar is the most likely vehicle to help lower the US balance of trade deficit, even as it continues to rocket higher today. A lower dollar will also make US exports more competitive, encourage Americans to save more and raise the prices of imported goods and services.

What they are not emphasizing or saying clearly is that there are many negative consequences of a lower US Dollar. They amount to a long and painful readjustment for Americans – higher inflation, higher interest rates, less consumer spending, lower housing prices, a generally slower economy, higher unemployment, a recession … AND THEN a real recovery.

And we will probably also have higher federal taxes, as the growing US federal deficit aggravates the situation.

Do you think a significantly lower dollar will lead to higher US equity prices and a continued healthy bond market over the next year or two?

Of course, it will not.

But a lower dollar is necessary to avoid more damaging consequences later. And at long last, the financial media, the Fed and Wall Street are starting to show that they understand that.

Following is a related front page article from the November 1, 2004 (today’s) Wall Street Journal. It is written by Greg Ip, probably the best writer on their staff.

Ken Wilson

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November 1, 2004

For Fed Officials Weighing Rates, Oil Price, Dollar Are Big Factors

By GREG IP
Staff Reporter of THE WALL STREET JOURNAL
November 1, 2004; Page A2

WASHINGTON -- Oil prices and the dollar are emerging as key factors for Federal Reserve officials ahead of next week's expected rate increase and the subsequent debate over whether to raise rates again in December.

Fed officials believe that the increase in oil prices since spring has damped what would otherwise have been a brisk expansion and that higher oil prices haven't raised inflation noticeably. That boosts the odds that the Fed will take a breather after it raises its key interest rate by one-quarter percentage point to 2% on Nov. 10, as is widely expected. Starting in June, the Fed has lifted its target for the federal-funds rate -- the rate at which banks lend to each other -- three times in quarter-point increments.

Further declines in the dollar, however, could encourage Fed officials to continue raising rates. They believe the dollar's relative strength, despite its recent dip, has slowed growth by fueling a record trade deficit, because a stronger dollar makes imports to the U.S. relatively cheaper and U.S. exports more expensive. That crimps American export manufacturers, limiting their role in the domestic economy. A weaker dollar could turn U.S. consumers more toward local goods, fueling domestic production and employment and boosting import prices -- all of which might argue for higher interest rates.

Fed officials cite high energy prices as the main risk to the economic outlook. "The recent run-up in energy prices poses some challenges," Fed Vice Chairman Roger Ferguson said Friday in a speech. Fed Gov. Ben Bernanke said earlier, "The recent rise in oil prices has ... been large enough to constitute a significant shock to the economic system," subtracting one-half to three-quarters of a percentage point from growth so far this year.

If oil prices retreat soon or if the pace of business hiring and investment spending picks up, the chances of another rate increase in December rise. Futures markets on Friday were predicting a less than 50% chance of a December rate increase.

Higher oil prices present a dilemma for the Fed because they crimp growth, which usually calls for lower interest rates, while boosting inflation, which calls for higher interest rates. But since June, long-term bond yields have tumbled, suggesting that markets don't expect a sustained upturn in inflation. Bond yields are sensitive to inflation, which erodes the value of the bondholder's return.

Fed officials cite several reasons not to fret too much over oil. Adjusted for inflation, the rise in imported oil costs is far smaller than what the U.S. experienced in the 1970s. In addition, overall prices have risen less than that of the much-sought benchmark West Texas Intermediate grade. And Fed Chairman Alan Greenspan said the recent stability of long-term futures prices suggests the latest jump in spot prices is temporary.

If Fed officials do raise rates next week, they will probably give little hint in their end-of-meeting statement as to what they will do next. They say their oft-repeated plan to raise rates at a "measured" pace could mean continuing to raise rates at each meeting, or pausing for a few meetings to gauge the economy's strength.

Still, the Fed's uncertainty about a December rate move represents a shift in its thinking. In raising the funds rate from 1% to 1.75%, the Fed was driven less by the ebb and flow of economic data than by a desire to raise the rate from an "emergency" level appropriate only when deflation was the main worry.

In recent weeks, Fed officials have emphasized the importance of incoming economic data in their deliberations, and de-emphasized the urgency of returning rates to "neutral." Neutral, in Fed jargon, means a level that neither stimulates nor restrains growth, and is commonly estimated at 3% to 5% in the long run. Mr. Ferguson last week said that in the near term, the neutral rate might be lower because business caution, high energy costs and the wide trade deficit are all restraining growth.

Another key factor drawing more attention from the Fed as it weighs interest-rate increases is the dollar.

The U.S. current-account deficit -- the shortfall on trade and investment income between the U.S. and the rest of the world -- has widened. That deficit must be financed by selling dollar-denominated assets, such as Treasury bonds, to foreigners. Textbooks predict that eventually will push the dollar down, and, in turn, make U.S. exports cheaper to foreigners and U.S. imports more expensive to Americans, and so reduce the trade deficit.

The possibility that the current-account deficit could trigger an abrupt run on the dollar and sudden jump in interest rates preoccupies policy makers around the world and was the subject of a special seminar at Fed officials' June meeting. Though Fed officials believe such a crisis is unlikely, they appear to broadly agree the dollar will have to fall to narrow the gap. Officials stress that they aren't trying to influence the dollar, a job they leave to the Treasury.

But they believe the failure of the dollar to fall further has contributed to the widening trade deficit, which, in turn, is hampering growth by hurting U.S. exporters' sales and siphoning U.S. consumer demand overseas.

"In order to offset this drag on demand for domestically produced goods and services, interest rates must be lower than would otherwise be necessary," San Francisco Federal Reserve Bank President Janet Yellen said two weeks ago.

Without the wider trade deficit, the economy would have grown at a 4.3% annual rate in the third quarter instead of the 3.7% reported Friday.

A drop in the dollar would encourage the Fed to raise interest rates more, because it would boost demand from overseas and put upward pressure on inflation via higher import prices. Some Fed officials would welcome this outcome. It would shift the growth toward U.S. export industries and away from already stretched consumers and housing, producing a more balanced expansion.

But Fed officials say they have no power to bring that about, and they are reluctant to forecast a continued decline in the dollar since it has defied expectations for so long. Moreover, like most policy makers, they don't consider the dollar the only way to shrink the trade deficit: A smaller U.S. budget deficit and stronger growth abroad would also help.

The Fed's staff, after repeatedly forecasting a sizable depreciation, no longer does, according to people familiar with the forecast. Mr. Greenspan has likened currency forecasting to flipping a coin. The dollar has declined about 3% since early September against the currencies of U.S. trading partners, leaving it about where it began the year.

http://online.wsj.com/search#SB109926865707360721