EMU Inflation Rises to 2.6%

Little more than a month ago, I predicted that Euro area inflation would easily rise to at least 2.5% by October or November this year from the 1.7% in August. Now, the flash estimate of euro area inflation indicates that it rose to 2.6% in October.

Yet even with inflation clearly above the ECB:s official ceiling of 2% and money supply growth way above the ECB:s official target of 4.5%, they are not expected to raise any more. All because the cowardly Frenchman, Jean-Claude Trichet, in charge isn't man enough too defy the monetary crank ruling in Paris, Sarkozy. Anyone who considers the ECB to be inflation hawks should really have their head examined.

This also illustrates again why we can't rely on written rules to restrain government officials. Just as most U.S. politicians -with very few exceptions, like Ron Paul- and most U.S. supreme court justices -with again very few exceptions, like Clarence Thomas- openly defy the U.S. constitution, so do the ECB board ignore the inflation targets they are supposed to follow. And this is not just true right now, money supply growth have exceeded 4.5% every single month since 1999 and consumer price inflation have exceeded 2% most of the time.

Why the Riksbank Will Have To Raise More

The Swedish Riksbank today raised as expected short term interest rates from 3.75% to 4%, which means that it now reaches interest parity with the euro area countries. And if as expected, the Fed cuts by another 25 basis points today, then that will mean that the spread between U.S. and Swedish nominal interest rates (As inflation and inflationary expectations are much higher in U.S., real interest rates is in fact already much higher in Sweden) will be reduced to 50 basis points, down from 175 basis points as recently as in August.

They will most likely have to raise interest rates again in the next few months. Money supply- and credit growth remains very high. And while some news papers have in recent days published anecdotal signs of falling house prices, that is likely misleading and more reliable reports indicate rising prices. And to the extent it is true that price increases have slowed down, that is likely a temporary factor related to how many Swedes wants to sell their homes before new year's eve to avoid the planned increase in the capital gains tax. With credit growth remaining high, with the housing tax reform and with construction levels remaining relatively low, prices should rise significantly next year, especially in the greater Stockholm area which is most affected by the housing tax reform.

Meanwhile, other factors including soaring food- and energy prices and higher increases in unit labor costs (i.e. wage increases uadjusted for productivity increases) is likely to help push consumer price inflation higher.

All of this means that the Riksbank will likely be forced to raise again.

Ron Paul vs. Ben Bernanke

Watch the only politician of any significance in America -and as far as I know the entire world- that is consistently committed to freedom and sound monetary economics, congressman and presidential candidate Ron Paul blast inflator-in-chief, Ben Bernanke for depreciating the value of the dollar and therefore stealing wealth from genuine producers and redistributing it in order to bail out Jim Cramer's Wall Street buddies from having to suffer the consequences from their losing investment strategy.

This happened just a few days after the Fed's 50 basis point cut in September.

The Fed's Next Move

BBC Business news speculates in another 50 basis point cut by the Fed on tuesday. They should of course raise rates considering the massive inflation we see in financial markets, particularly commodities, and at the very least repeal the September cut and preferably go even higher than that, but that is simply not going to happen. There is a small probability of both unchanged rates and a 50 basis point cut, but a 25 basis point cut seems like the most likely move. However, I regard the probability of a 50 basis point move to be higher than unchanged rates. Bernanke showed, as Cyndi Lauper would have put it, his true colors when he made the 50 basis point cut in September, and so even though another 50 basis point cut would be insane with $92 oil and $787 gold, I wouldn't dare to rule it out. Still, with some at the Fed presumably somewhat more sane, a 25 basis point cut remains more likely.

The Swedish Riksbank will by contrast probably raise rates another 25 basis points, reaching 4%. The Swedish krona reached a post-1992 peak of 6.38 versus the dollar on Friday. With the interest differential being reduced from 175 basis points to likely just 50 basis points -25 if the Fed cuts by 50 points- the rising trend of the Swedish krona versus particularly the U.S. dollar will likely continue.

Dagens Nyheter vs. The Facts

Dagens Nyheter's journalists are setting new lows in journalistic quality. While other media outlets such as marketwatch.com may offer faulty analysis, at least the numbers they present are correct.

But for Dagens Nyheter facts seems irrelevant. First, as Johan Norberg points out, Ulrica Kärnborg slander Milton Friedman on a number of issues, by for example blaming him for the mess in Iraq, even though he opposed the Iraq war.

Then there is this article about the Irish economy. While the article seems to be written by news agency TT, Dagens Nyheter of course endorses the text by publishing it.

The worst part about the article is not the analysis, which is somewhat misleading but not completely incorrect, but the big factual errors. For example, the article claims that construction is 15% of Ireland's GDP. Wrong, it is only 8.5% of GDP.

The article also claims that government spending rose from SEK 150 billion in 1997 to SEK 510 billion now (it is unclear whether that is supposed to mean 2006 or 2007), which in euros would be an increase from €16 billion to €55 billion. In reality, government spending was €24 billion in 1997 and €56 billion in 2006. And even this is misleading, since this represented a decline in the government spending to GDP ratio from 35% to 32%.

And then the article claims that government employment increased from just from 69,000 in 2002 to 310,000 now. Not true, as in reality government employment were 336,000 already in 2002, and have only increased by 25,000 to 361,000 since then. And again, even this alleged increase is misleading as this represents a decline in the proportion of total employment in the government sector from 19% to 17.5%.

That most journalists aren't hired on the basis of competence seems increasingly clear.....

The Fed Rate Cut & The Gold Price

A strange notion has been spread among some pro-inflation supply-siders. Namely, that interest rate cuts and higher money supply might actually strengthen the dollar and so lower the gold price and consumer prices. The idea is that the interest rate cuts will strengthen economic growth and therefore increase the supply of goods and services even more than the supply of money, leading to lower, not higher, prices. The idea is really so absurd that I wouldn't have bothered refuting it hadn't it been for the fact that pro-inflation supply-siders are so influential within the Republican party and pro-Republican media outlets like National Review and Investor's Business Daily.

The idea that even the short-term elasticity of production to money supply is more than 1 is of course not backed by any empirical evidence whatsoever and would require completely unrealistic assumptions about how the economy works. So there is not really much to refute as no evidence exists. However, just to illustrate how absurd the theory is and how out of touch with reality these supply-siders are, let's look at what one of them, Larry Kudlow, wrote just after the Fed rate of September 18:

"I also suspect that over time, the improved economic growth outlook for the U.S. will actually strengthen the dollar’s exchange rate, in part because the interest tax on money has been lowered.

And while gold did rally immediately after the Fed move, I would look for some gold weakness along with a better dollar."

Almost six weeks has gone now and gold is now trading at more than $785 per ounce of gold, up 9% from the level it stood at before the Fed rate cut. One can really wonder when that gold weakness that Kudlow predicted will come. The truth is that it's not going to come anytime soon. While temporary corrections will certainly come, the trend will however certainly be upwards due to the massive inflation unleashed by the Fed. I regard it as a near certainty that gold will push through the 1980 all time high of $850 per ounce within the coming 12 months-maybe even as soon as during 2007, although that is less certain.

Marketwatch Nonsense About Greenspan & Housing Bubble

This marketwatch article seems promising if you just look at the headline "Roots of credit crisis laid at Fed's door". That is of course a statement of the all too obvious. There is no question at all that the Fed and Alan Greenspan is guilty. More specifically the blame must be laid at their senseless decision to cut interest rates from 6.5% to 1.75% in just one year, 2001, and then down to 1% in 2003, and then only raising it at a "measured pace" from the second half of 2004.

The problem is that the article doesn't in fact mention Fed interest rate policy at all, and instead focus on the irrelevant side issue of Fed regulation of banks. It is telling that the article doesn't even mention what kind of regulation the Fed should have enforced and would have prevented the bubble.

To make matters worse, the article quotes Greenspan writing in his book something unusually confused even for him.

"In his recent autobiography, Greenspan said when he accepted the top Fed job, he worried that his Ayn Randian brand of libertarianism would make it difficult to be a bank regulator and said he planned to allow others at the Fed to take the lead."

Say what? If one really believes in the "Ayn Randian brand of libertarianism" and interprets this as resistance to regulation of banks, why is it a problem if it results in less regulation? And if one believes lack of regulation is a problem then why is it a problem to enforce it.

While financial journalists often present misleading analysis, this one, Gregg Robb, is unusually confused. It overlooks the key issue of interest rate policy and instead focus on the irrelevant issue of regulations they can't even specify. And then he presents the confused rantings of Greenspan where he thinks he has some kind of psychological problem in pushing through a policy he believes is right, as some kind of argument for this still unspecified policy. Puh-lease......

Bryan Caplan's Strange Questioning of China's Boom

Bryan Caplan here questions Chinese economic statistics showing rapid economic growth.

Now, it is certainly justified to show a healthy dose of skepticism toward government statistics, and Chinese government statistics is probable not more reliable than most other countries. However, in the case of China there is stronger reason to believe that official statistics underestimate growth than overestimate it, given China's prominence in international trade and given the fact that it is the biggest or second biggest consumer of almost all commodities in the world. And Caplan's arguments are of really low quality.

His first argument is that a too high proportion of the population is in agriculture and that the productivity gap between farmers and the rest is suspiciously high. Actually, first of all, the 60% number refers to rural population, not farmers, which is not the same as some in the rural population works in small scale manufacturing and services. And secondly, as the productivity of workers in industry and services is confirmed by China's high level of foreign trade and commodity consumption, if the real productivity gap is smaller than the official that would imply higher farm productivity rather than lower nonfarm productivity.

His second argument, that savings are too high for a growing economy is even worse. Savings and the investments it enables is what drives economic growth by not only providing demand but also increasing production capacity. Consumption on the other hand is simply demand and does not increasing supply. So it is certainly nothing strange about a high savings rate being associated with high growth, it would be by contrast be strange and suspicious if you find a country with high growth and a low savings rate.

Poland New Flat Tax Country

In Poland, the relatively free market Civic Platform Party headed by Donald Tusk won in the elections over the more socially conservative Law and Justice Party, headed by the identical twin Kascynski brothers.

While the Kascynski government has actually also lowered the burden of government and so helped Poland achieve 6-7% GDP growth, Donald Tusk and his party has promised to privatize and cut spending even more, and also replace the current income tax with a low 15% flat tax. If that happens, then economic growth could rise to levels as high as 10%, like it did in Slovakia after they introduced their 19% flat tax.

Spending Cuts What's Important

Jurgen Reinhoudt from the American Enterprise Institute has an article about the Irish economic miracle which illustrates the shortcomings of supply-side economists.

While he rejects the false claim that money from EU structural funds was responsible for it by pointing out that other mayor receivers, particularly Portugal, failed to grow at anywhere near Irish levels, his attempt to refute those who deny the role of free market economic policies is unsatisfactory to say the least. Here is what he wrote:

"Some allege that Irish economic growth “came first,” which then enabled tax cuts to be passed, rather than the other way around. It is difficult to disprove this theory, but it is not difficult to see that Ireland’s growth would almost certainly have stalled had no tax relief been enacted from the early 1990s onwards. Regardless of which came first, tax relief—particularly corporate tax relief—has played an indispensable role in Ireland’s economic success."

That is about as unconvincing argument as it gets. He provided no evidence that growth would have stalled without the tax cuts, but merely asserted it.

The truth is that while growth took of before the tax cuts, it didn't take of before spending cuts. In the mid-1980s Ireland had an enormous budget deficit, at over 10%
of GDP and government spending at over 50% of GDP. Ireland then reduced the deficit by deep spending cuts, which allowed interest rates to fall sharply and confidence return in Ireland's economic stability.

Reinhoudts focus on only tax cuts, illustrate the problem with supply-side economics. They view government spending and deficits as irrelevant, or even positive, and only focus on tax cuts. This leads them to misleading analysis, such as their prediction that the Bush tax cuts would significantly increase growth even through they were combined with higher spending and deficits and even though the economy has been damaged by Greenspan's monetary policy. Or in this case, when they fail to explain why growth in Ireland preceded the tax cuts.

The Economist Wrong On Baltic Story

The Economist generally has the highest quality of all mayor news magazines, often expressing semi-Austrian points of views. Sometimes however they too get the story wrong and express points of views which are Keynesian or otherwise misleading. So is the case in their story on the problems of the Baltic economies, and the Latvian economy in particular, which looks dangerously overheated.

In the story, devaluation is presented as the solution to Latvia's problems with 11.4% consumer price inflation and a current account deficit of 23% of GDP. But while a substantial devaluation could reduce the current account deficit, at least in the short term, it would certainly not solve the problem of excess inflation. Quite to the contrary, it would in fact aggravate that problem by putting upward pressure on import prices too.

While I certainly agree that the Latvia and the other Baltic economies should drop their peg to the euro, the point of that is not to lower the value of the currency. The point is, or should be, to tighten monetary policy and raise interest rates dramatically in order to rein in money supply growth and price inflation. By reducing domestic demand that would both reduce price inflation and the current account deficit. While that might cause a recession, in the long run it would be healthier to deal with the excesses now rather than allowing things to get worse,

If on the other hand the point of dropping the peg is to devalue, the result would only be more inflation and aggravate the problems of the Baltic economies.

Financial Journalist Thinking in Action

Mark Hulbert of Marketwatch shows just how clueless he and all too many other financial journalists are about sound economics when he asks "Why hasn't high-priced oil, now nearly $90 a barrel, killed the stock bull market?" without really being able to answer that question.

But in fact, this question is extremely easy to answer. While one external factor, the threat of a Turkish invasion of oil-rich Iraqi Kurdistan have also contributed to the recent oil price rally, the main reason for higher oil prices isn't related to supply. Instead the stock market rally and the higher oil price is caused by a common factor: extremely loose monetary conditions in the U.S., with MZM being up at an annual rate of 25%.

You Ain't Seen Nothing Yet

Consumer price inflation rose to 2.8% in September, up from 2.0% in August.The monthly rise was actually only 0.3%. With commodity prices going through the roof (Oil at $87, gold at $765), one is tempted to scoff at the alleged limited price increase reported by the government.

I agree that the government numbers underestimate price inflation, but they are still likely to mostly move in the same direction as true price inflation. And even the government numbers will increase a lot more soon. With oil prices up 25% from mid-August, the mere 0.3% increase in energy prices is nothing compared to the rises we can expect later. The increase in gasoline prices is limited somewhat by reduction in refinery margins, but even so, gasoline prices are rising. And ultimately, the reduction in margins is unlikely to be sustainable.

Similarly, food price inflation will if anything continue to accelerate from its current 4.5% level. With food commodities up 36% the latest year (up 10% since mid-August), finished food products will certainly continue to rise at least at the current level, likely even faster.

The monetary basis for the sharp increase in commodity prices, the falling dollar, the increasingly overvalued stock market and the likely acceleration of official consumer price inflation can be seen here.

Excellent!

House Energy And Commerce Committee Republicans have this hilarious parody using Simpson's characters of what the Democrat's position on SCHIP, which means raising tobacco taxes -largely hitting low income earners- to pay for middle class children's health care, really mean:

"Republican businessman Montgomery Burns today joined with Mayor Joe Quimby, D-Springfield, to support the Senate’s gazillion-dollar SCHIP bill.

“If the poor children can get a piece of the action, why can’t I?” explained Burns at a MoveOn.org rally in Capital City. “The little darlings are needy? Me, too. I need somebody to pay. Quimby here says he knows a bunch of low-income nobodies who are ripe for the picking. Excellent.”

“You need this?” wondered the mayor. “Well, why not. I’ve got needs, too. Why, I’ve got 27 paternity suits pending and to quote the Speaker, ‘suffer the little children.’ The Quimby Compound is overflowing with those little sufferers. Vote Quimby.”"

Higher Unemployment Benefits-Higher Unemployment

New study confirms the obvious-if you subsidize unemployment more then you will have more unemployment. The authors evaluate recent Finnish experience after they in 2003 raised short-term unemployment benefits for the first 150 days of unemployment. The result was that the duration of unemployment for those receiving the higher benefits rose significantly even as it actually fell for those not eligible for the increased benefits. The authors estimate that the 15% increase caused a 31 day increase in umeployment duration.

Not exactly shocking results, but when Social Democrats try to deny the obvious truth such studies can be valuable.

Roots Of Inequality

Swedish media, quoting Wall Street Journal reports that income inequality reached a record level in America in 2005, with the top 1% of the population earning 21.2% of all income, up from 19% in 2004 and beating the previous record of 20.8% in 2000.

Bush blames educational factors, and uses this to promote his "No Child Left Behind" program while Democrats blame foreign trade and weaker unions and lower minimum wages and paleoconservatives blaming foreign trade and immigration. Yet the most important factor is the one the Wall Street Journal reporter discusses: the booming stock market. That is of course why inequality peaked at the peak of the tech stock bubble and fell when that bursted, and is now rising again as a new stock bubble is being inflated. Inequality therefore probably rose to even higher levels in 2006 and 2007.

And the cause of overvalued stock prices is of course monetary inflation, while inflation at the same time hurts people with low income to a disproportionate . Which makes it ironic that most leftists only attack the Fed for inflating insufficiently.

Swedish-EMU Interest Parity Again?

Consumer price Inflation rose significantly in Sweden in September. The EU-harmonized index rose from 1.2% in August to 1.6% in September, the national index from 1.8% to 2.2% and the Riksbank's version of core inflation (excluding interest rates, taxes and subsidies, rather than food and energy) rose from 0.7% to 1.0%.

This was more than most market participants had expected and so the Swedish krona rose to a new post-1992 high against the U.S. dollar and it also rose against the euro and most other currencies. It may seem like a paradox that the news that the domestic value of the krona fell would cause an increase in the foreign exchange value of it, but the explanation is of course the expectation that this will cause the Riksbank to raise interest rates.

And that looks increasingly likely, perhaps as soon as the next meeting. With ECB rates staying unchanged indefinitly, this would mean that for the first time since 2005, there would be parity between Swedish and Euro area interest rates.

And the Riksbank looks a lot more likely than the ECB to raise more after that, with Swedish growth staying strong due to a combination of rapid credit- and money supply expansion and supply boosting tax and spending cuts from Sweden's centre-right government. At the same time, soaring food and energy prices along with high wage increases pushed through by unions earlier this year means that further increases in inflation looks likely. So, it seems likely that Swedish short-term interest rates will be higher than in the euro area in just a few months.

All of this is of course very bullish for the Swedish krona, who will likely continue to rise against both the euro and the U.S. dollar.

Hong Kong Leader: 16% Top Income Tax Too High

Hong Kong leader Donald Tsang announced today that they will cut the top personal income and corporate income tax to 15% and 16.5% in order for the territory to remain competitive. This should be viewed in the context of a tax cut implemented by arch-rival Singapore earlier this year.

Two decades ago, Tokyo was the dominant Asian financial centre. While Tokyo is still large in terms of market value of its companies, it is nevertheless becoming more and more of a "has been" financial centre. Tokyo almost exclusively list Japanese companies and the relative importance of the Japanese economy in Asia is rapidly declining due to its falling population, weak economic growth and weak yen.

Hong Kong is now in a fierce battle with Shanghai and Singapore about who will replace Tokyo as Asia's most important financial centre. Asian leaders, like Eastern European leaders, but unlike certain Western leaders -This means among others you, Fredrik Reinfeldt and Anders Borg- realize the importance of attracting and not discouraging high achievers.

Profit Growth Slowing Sharply

A wave of earnings warnings in recent days, from particularly banks but also energy companies and International Paper, means that official profit growth estimates for the S&P 500 companies is likely to turn negative. Just last week, I reported them to be 3%. Actual earnings growth might actually still end up at 3% as companies on average always beat the official estimates that is presented just before the reports, on average by 3%. Still, 3% would be unusually low and it implies that stocks are very expensive indeed, considering that prices are 16% higher than a year ago. Loose monetary conditions and hopes of more Fed rate cuts could perhaps push stocks even higher in the coming weeks despite the fact that stocks are highly overvalued, but clearly the downside risks are much greater than the upside potential.

Moreover, it seems safe to say that the entire increase and more will come from foreign operations, as the sharp decline in the dollar not only raises margins of exporters but also raises the dollar value of foreign profits. If say half of all profits are foreign and the dollar falls 10%, then even if the dollar value of domestic profits are flat and even if the euro or pound value of foreign operations profits are flat too, then the dollar value of total profits rises 5%. And with the S&P 500 companies being far more globalized than other American companies, then this implies that we likely saw falling profits even in nominal terms for the U.S. economy as a whole. That is very bearish for business investments, of course.

Ukraine Overheating Too

It's not just the Baltic states that have a problem with inflation. Ukraine has it too, with consumer prices being up 8.6% since December 2006 and 14.4% since September 2006.

In Ukraine, inflation is home made and not, as in the Baltic states a result of a currency peg. Of course, my recommendation to the Baltic states to drop the peg only applies if they do it in other to reduce inflation. If they were to inflate as much or more on their own, as in Ukraine, then it would be better to keep the peg,

More Reason To Be Bearish About U.K. Housing Market

Owning a home is now 1.5 times more expensive in Britain than renting one. Traditionally it has been roughly equal in cost, but as house prices have increased far more than rents, that have changed.

Today's Quote

Peter Schiff on inflation:

"In actuality, officially benign inflation statistics (which are coming at a time when actual inflation is getting worse) give the Fed further cover to create even more inflation. So the dollar is not weak because inflation is under control as the consensus believes, but because the opposite is true. Inflation is completely out of control and the Fed, hiding behind phony government numbers that purport otherwise, has the green light to add additional fuel to inflation’s fire. It’s the ultimate irony that the lower the official preferred measures of inflation are (core CPI or the core Personal Consumption Expenditure Index,) the worse inflation actually gets."

Oh No! The Japanese Will Get Cheaper Mobile Phone Calls!

You know the economics of all too many financial journalists aren't sound when they write stories like this. Financial Times report about a big "threat" to the Japanese economy-household will get cheaper mobile phone calls. And so the problem is.......?

Well, that is a valid question and the correct answer is that it isn't a problem. It is in fact good as the purchasing power of these households will rise. But to the Financial Times journalists,David Pilling and Mariko Sanchanta, this is supposedly a problem because this will mean that the rate of consumer price deflation in Japan might rise. But first of all, with the weak yen and rising oil prices, Japan is more likely to see the CPI yearly change rise above zero than fall deeper below it, cheaper mobile phone services notwithstanding. And secondly and more importantly, price deflation driven by higher supply is not a problem. The computer industry have had it for decades and it is thriving. All too many journalists are so ignorant of sound economics and economic history to know that price deflation will only be bad for economic growth when it is caused by monetary deflation, not when it is driven by a higher supply of goods and services.

EMU Politicians Act To Weaken Euro

When I first predicted in July that the euro would rise above the 1.40 level against the U.S. dollar, I also cautioned that it would have a difficult time rising much further after that as Euro area exporters and politicians would try to act against further euro appreciation and as the ECB would then find it difficult to raise interest rates further.

Well, the ECB has already seemingly indefinetly postponed any further rate hikes and now we see massive complaints from euro area exporters and politicians. And this it's not just Sarkozy, but also Italian prime minister Romano Prodi and German chancellor Angela Merkel.

Prodi said that "There is concern that US policy is very attentive exclusively towards domestic interests". Actually, it's not really focused on broader U.S. national interests, but rather on the interest of Jim Cramer's Wall Street buddies who demanded to get bailed out from their failed investments by Bernanke's money helicopters. But he is right that Bernanke certainly don't care about Europe.

While it is understandable that exporters are unhappy about this, the euro area hardly faces a real crisis with regards to its external balance. In fact, the euro area has a growing current account surplus.

A far bigger problem is the rising domestic inflationary pressures. And while rhetoric like this can temporarily push down the euro's exchange rate somewhat, ultimately the only thing that can stop it is if the ECB follows the Fed and starts to inflate even more. You cannot at the same time control both domestic inflation and the exchange rate, you have to choose. So will Trichet choose to safeguard the broader European interest of containing inflation or the narrow interest of a few exporters? Unfortunately, it seems that Trichet will follow Bernanke in choosing to increase inflation.

Bush Veto Spending Increase

Bush today vetoed a bill for a fourth time-and for the third time it was a spending bill. Two of the previous occasions were about federal funding of stem cell research and one was a bill where the Democrats pretended to try to end the Iraq war (In reality they knew and hoped their "attempts" would fail). In the case of stem cell research funding, Bush did the right thing for the wrong reason while in the case of Iraq he did the wrong thing period. In this case he did the right thing for the right reason.

As Bush points, the Democrats plan to expand government health insurance coverage for children would actually redistribute from the poor. Poor children are already covered by Medicaid or the original plan, so only middle class households would gain. Meanwhile, the higher tobacco taxes designed to finance it would hit the poor disproportionally hard. It is also an unsustainable financing source since smoking is going down while the number of children covered by the program is going up, meaning it would likely expand the budget deficit.

Did Anyone Say Stagflation?

While the ISM indexes aren't always reliable, they usually are. The ISM non-manufacturing index fell in September, with the key new orders sub-component falling particularly much. However, the prices paid index rose significantly, all pointing to stagflation.

Liquidity Driven Stock Rally-Again

Financial journalists don't know what to make of the seemingly puzzling stock market rally yesterday that meant a new all-time high for the index journalists for some reason focus on-the Dow Jones Industrial Average. Here is CNN Money on the issue:

"Stocks have been on a run recently on hopes that the worst of the credit crunch is over and on expectations that the Federal Reserve will keep cutting interest rates."

But if the worst of the credit crunch is over, the Fed isn't likely to cut interest rates. Good thinking, Beavis.....

It was seemingly puzzling because the day featured only bearish news, such as earnings warnings for Citigroup and UBS and a weaker than expected ISM manufacturing index. Yet even though there was only bearish news-the stock market rose more than 1%. What's up with that?

The reason why the stock market rose yesterday is basically the same reason for why it has risen more than 10% since mid-August. It is also the same reason that explains why the dollar has dropped roughly 5% and commodity prices risen more than 10% during the same period. The explanation spells massive monetary expansion.

If you adhere to the narrow money supply definitions of Frank Shostak and his followers, such as Mike Shedlock and Gary North, these movements would indeed seem unexplainable, as M1 actually fell more than 1% between August 6 and September 17. It is also down 0.1% compared to the same period last year.

However, if you look at MZM, it is up 3% in that same period, which is equivalent to an annualized increase of 29.2% and up 11.8% in the latest 52 weeks. Similarly bank lending is up 2.1%, or 19.5% at an annual rate (some "credit crunch"), and up 11.6% in the latest year.

This again illustrate that not only is MZM better than M1 from an essentialist point of view, it is also far, far better in explaining economic trends in general and financial market movements in particular.

Given the extremely loose monetary conditions, it seems possible and even likely for the U.S. stock market to continue to make new highs for a while. However, I don't think the rally will continue for much longer. Because first of all, most stocks are very expensive from a fundamental point of view. Stocks are up more than 16% in the latest year even though earnings are likely to be up only 5-6% (official estimates point to 3%, but as they are always beaten we should add a few percentage points), so they are in fact roughly 10% more expensive. Stocks are arguably more overvalued now than at any time in history except for the late 1920s and late 1990s.

Moreover, contrary to Wall Street expectations the Fed's room to cut interest rates is limited as even official consumer price inflation is likely to rise sharply. They will probably still cut in the next meeting, but after that, the surge in inflation will tie their hands.

European Central Bank's Insane Gold Sales

The Swiss central bank announces it has sold 113 tonnes of gold (3.6 million ounces, which at current value is $2.7 billion, although when they sold it the price and accordingly also their revenues wer lower). The Swedish Riksbank also announced it has sold gold again, although they "only" sold 10 tonnes (320000 ounces at a current market value of $240 million). ECB membership banks also probably sold a few hundred tonnes of gold.

There are several points that can be made in relation to this. First, it is noteworthy that the price of gold has been able to rise significantly despite these massive sales from European central banks. Imagine how much gold would have risen in absence of those sales.

There are four reasons why the gold price has kept soaring despite these central bank sales. First of all, gold's rise has been a lot more moderate in most other currencies and the rise in its dollar price to a large extent reflects the decline of the dollar. Which brings us to reason number two, which is that central banks have inflated more and more and an increasing number of people realize that central banks will continue to inflate and probably inflate even more, which means that the demand for gold as an inflation hedge increases. Reason number three is that many emerging economy central banks, including that of Russia and India have in contrast to the Western central banks actually increased their gold reserves. Reason number four is that non-monetary demand for gold (for example as jewelry) in many emerging economies, particularly China and India is increasing rapidly.

Another aspect of this is just how bad investors these central banks have been. I called attention to and argued against the Swedish Riksbank's gold sales -10 tonnes or 320,000 ounces then as now- back in 2005 and 2006.

I warned both in 2005 and 2006 that the Riksbank would lose a lot of money from this, and I have been proven right. If you look at the prices I discussed in these posts, you can see that the price was $416 per ounce in 2005 and $600 per ounce in 2006. As the Riksbank said it would re-invest the proceeds from the gold sales in foreign government bonds, this means with interest rates of 4.5%, that the value from the first sale is equivalent to $454 per ounce (416×1.045×1.045) and $627 (600×1.045) per ounce. Compare this to the current gold price of $750 per ounce. The morons at the Riksbank have thus lost a total of $137.3 million ((320,000× (750-454))+ (320,000× (750-627))) or nearly SEK 900 million. To be sure, the real number may be somewhat lower since this calculation is based on U.S. government bonds, so to the extent the Riksbank invested in European government bonds whose exchange rate adjusted returns were better, the losses were smaller. However, we're still talking about at least -probably more like 600 or 700- SEK 500 million in losses from these idiots strategy to switch from gold to government bonds, which was laughably motivated by a desire to "increase [sic] the risk-adjusted return"

Why the hell aren't the morons responsible for these massive losses fired? And how come they're allowed to continue with their losing strategy? Because mark my word again, gold will continue to outperform government bonds, particularly U.S. government bonds, but also European ones.

However, there could of course be an alternative explanation to incompetence for these seemingly insane gold sales. Central banks could -I'm not saying this is certain, but it can't be ruled out- have an ulterior motive for this action. The Chinese central bank presumably know that they will have negative returns from their U.S. government bond holdings, but they keep buying them to prevent the yuan from rising in value faster than it desire. Similarly, central banks in the West know that many people consider gold to be a good inflation hedge and inflation indicator. And as central banks have a vested interest in keeping down inflationary expectations they also have a vested interest in keeping down the gold price. This is of course is what gold sales achieve, all else being equal.

No Price Inflation-If You Exclude Prices That Rise

Daniel Gross has a surprisingly good column for being published in a outlet as big as Newsweek. Normally, only The Economist among mayor news magazines publishes columns this good.

In it he mocks the "core" inflation concept as well as Alan Greenspan and also points out that price inflation is likely to rise fast.

For my own general critique of "core" inflation see here. For my critique of an argument I heard after writing that article, namely that "core" inflation allegedly better reflect inflation trends and because of that helps predict all-items inflation see here ( In reality as I demonstrate in the post, the empirical relationship existing works in the opposite way so that movements in all-items inflation predict movements in "core" inflation).