Aaron Daniels, MIM

With the US Dollar holding its value (or lack of value) against foreign currencies, US made goods are once again becoming affordable around the world. Overseas buyers with stronger currencies (in relation to the US Dollar) are finding more purchasing power with US exports vs. domestically manufactured goods. And with the US Federal Reserve financing decades of deficit spending by selling greenbacks overseas, foreign buyers have an enormous supply of US Dollars with which to purchase US goods.

However, while the weak US Dollar is stimulating US exports, a convergence of other events is making the correction in the US balance of trade a dangerous situation for the US economy. With US Dollars returning to the US to purchase goods, the net effect is an increase in supply of dollars domestically. This is increase in supply of dollars is a textbook cause of inflation:

Mainstream economists believe that high rates of inflation are caused by high rates of growth of the money supply.

But the Federal Reserve is currently fighting another battle – an economy teetering on the brink of recession. Traditional treatment for such an economic ailment has been to lower the Federal Funds Rate (the rate at which banks can borrow money) in order to make money and loans more readily accessible. Releasing money into the economy this way makes it possible for businesses (borrowers) to grow, sparking economic growth.

In this case, the treatment for the more immediate economic ailment (recession) will actually worsen the other (inflation). Like a giant locomotive, the economy moves slowly, but with great force. This is exactly why the Fed alters the Federal Funds Rate in 1/4 to 1/8 point increments. The slightest of corrections can have enormous and unanticipated consequences later down the road.

There is another market driver that is having a quicker effect on the economy, and this one the Fed has no control over: the rising cost of fuel.

Inflation is a rise in general level of prices of goods and services over time. Although “inflation” is sometimes used to refer to a rise in the prices of a specific set of goods or services, a rise in prices of one set (such as food) without a rise in others (such as wages) is not included in the original meaning of the word. Inflation can be thought of as a decrease in the value of the unit of currency. It is measured as the percentage rate of change of a price index^[1] but it is not uniquely defined because there are various price indices that can be used.

In the US we are just beginning to see the effect of rising fuel prices on the economy. Food prices are starting to soar. As food and fuel get more expensive, wages will have to be raised to compensate for the increased cost of living. The net effect of this will be a domestically devalued dollar, thus starting a vicious circle of inflation.

I don’t believe we will see the full effect of the convergence of these economic drivers until later 2008/2009. But when we do I think we will relive the economic chaos of the late 1970′s.

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