EMU Inflation Reach 4%

Today, Eurostat issued a preliminary estimate of Euro area price inflation in June. It rose to a new all time high of 4%, up from the previous all time high of 3.7%. Compare these numbers to the supposed target of 2%.

This will put further pressure on the ECB to raise interest rates in addition to the already signaled hike at the next meeting, especially if as I expect, inflation rise further in July and August. And while M2 money supply growth slowed somewhat in May to 10.1%, from 10.4% in April, it remains at a level which is certainly high enough to fuel more future price inflation.

Report On Swedish Monetary Policy Released

Today my report on Swedish monetary policy from the perspective of Ludwig von Mises' theories for Swedish free market think tank Timbro was finally released. So I recommend those of my readers that understand the Swedish language to read it here.

Bank Credit & Money Supply

Three of the more prominent "deflationists", Mike Shedlock, Paul Kasriel and Caroline Baum, have recently made a big deal out of the apparent contraction of bank lending since March. This supposedly proves that monetary conditions have become deflationary.

This is a quite interesting development since these 3 writers completely ignored this indicator when it expanded sharply, which it did until March. Instead they focused on the monetary base, which is now ignored, perhaps because it by contrast have begun to accelerate in recent weeks from its previous weak growth rate.

But setting aside their convenient flip-flop in chosen indicators, does this development indicate a shift in monetary conditions?

No, not necessarily, and no evidence exist yet that it does.

First of all, as I explained in my post Assets & Liabilities & Myths About Write-downs bank credit is part of the asset side of bank balance sheets, while money supply is on the liability side (all too many economists, including presumably the aforementioned three, aren't educated in accounting so they don't understand these sort of things).That means that although bank credit and money supply are usually correlated with each other, they need not be and often aren't. And as I also explained at the time, while bank credit will be reduced as a result of write-downs, the components of the money supply will be unaffected (except maybe indirectly at a later point in time). And while money supply growth have slowed somewhat it is still quite high.

Nor are bank credit equal to total credit. Commercial bank lending totals only $6.9 trillion, or less than 30% of total private sector debt. One reason for the slowdown in bank lending is likely that conditions on the credit markets have improved, enabling companies who want to borrow to get capital from the credit markets rather than the banks. The super high growth rate in bank lending between August 2007 and March 2008 reflected to some extent the collapse in commercial paper issuance, but in recent weeks this have started to stabilize and rise again. It would be interesting to see statistics over total private sector debt, but as far as I know no such statistics will be available until the next flow of funds release on September 18.

I should finally emphasize that I have no permanent commitment to the inflationist (inflationist/deflationist in the sense of forecasting the future, not advocating policy) outlook. If the facts change, then I would have no problem changing my outlook. However, until total debt growth and more importantly, money supply growth halts, I stand by the inflationist outlook. And that wouldn't in anyway make my current assessment wrong. Furthermore, the lagged effect of current monetary inflation is likely to keep price inflation high. However, if monetary conditions would become less inflationary this would relatively fast contribute to lower commodity prices.

The Role Of Speculation & Governments In High Oil Price

On LRC today I analyze the role of speculation vs. government policies in causing the high price of oil and other commodities.

But McCain Doesn't Claim To Be An Economist

Greg Mankiw criticizes the John McCain comments mentioned in the previous post, by sarcastically stating that John McCain's crystal ball foretold those things.

Yet while McCain judgment can be questioned because he uses the same economists that he derided, he did actually have a point about the non-Austrian economists who constantly fails to predict the future. And Mankiw's retort to McCain was quite unfair because McCain has never claimed to be an economist. In fact, he has explicitly stated that he does not know much about economics.

Now of course, not even the best economist can predict the future perfectly because not all relevant information is available. However, if you follow correct theories and applies them to the relevant available data, then you should get things right most of the time. This is the same as meteorologists. Their forecasts about the short-term weather outlook are not always correct, yet they are certainly more often correct than random guesses.

Compare this to the miserable state of economic forecasting from non-Austrian economics. The vast majority of economists have virtually never been able to forecast a looming recession before it arrives. And even the few non-Austrians that have been able to forecast it, such as in the case of the latest one, Nouriel Roubini, have gotten other details wrong, such as their forecast that the recession would cause commodity prices to plunge and so also cause price inflation to collapse. With regard to that latest issue, Austrians who follow Frank Shostak's money supply definition, such as Mike Shedlock, have also gotten things wrong.

This is all the more embarrassing for the non-Austrians as their ridiculous mathematical models are often justified because the mathematical rigor and formulation will allegedly give the theories more predictive power. But because those theories and mathematical models are completely out of touch with reality, they have in fact absolutely no predictive power whatsoever (as is illustrated by the failures that McCain pointed to), in contrast to the strong predictive power of the verbal Austrian theories.

That's Your Own Advisors You're Mocking

Via Lew Rockwell I find this statement from John McCain:

"You know the economists? They're the same ones that didn't predict this housing crisis we're in. They're the same ones that didn't predict the dot-com meltdown. They're the same ones that didn't predict the inflation that's staring us in the face today."

Actually, there were economists, including me, who identified the housing bubble and predicted it would cause a recession. Some of these, including me, also correctly predicted that this downturn would be associated with high inflation.

Of course, most economists didn't predict the current stagflation. Interestingly enough though, some of them are in fact those who now serve as McCain's advisors or media supporters, including Don Luskin, Larry Kudlow and Kevin Hassett. So what McCain is saying is that the analysis of Luskin and his other advisors is useless. Of course, I agree with McCain on that, but it makes you wonder why he hires them as advisors.

Price For (Almost) Everything Except Houses Rise

Today we learned that house prices in the U.S. continues to fall. By 15.3% according to the Case-Schiller index and 4.6% according to the OFHEO index. The Case-Schiller and OFHEO indexes are constructed in different ways, which is why the numbers differ. Case-Schiller probably overstates the decline because it only covers big cities where the previous increases were largest. OFHEO on the other hand probably underestimates the decline because it does not cover all house transactions and excludes those most closely associated with the bubble. So the true number is likely somewhere in between, although it is probably somewhat closer to OFHEO.

However, the price of commodities continues to go up. Chinese steelmakers just agreed to a 85% increase in the price of iron ore they pay to Australian miner Rio Tinto. This means yet another windfall boost to the Lucky Country, which is bullish for the Aussie dollar. It also implies that inflation remains strong in the goods markets.

The combination of high inflation in the goods and services markets and deflation in the housing market was captured in this The Economist cover from May 24, where one says that the price of everything seems to be going up, to which another reply "except my house price".

The Speculator As Oil Price Scapegoat

I'll return soon for a more in-depth analysis of the scapegoating of speculators as responsible for high oil prices by statist politicians like Joe Lieberman, Barack Obama and Nicholas Sarkozy, but for now I recommend you to read this article in The Australian (Thanks Chris for the link)about why central banks rather than speculators should be blamed.

UPDATE: Like I said, I'll very soon, probably by tomorrow, write my own analysis on the subject. But in the meantime, I've found two other good writings on the subject, one by Paul Krugman and one by Robert Murphy.

End Of Yen-Stock Market Link?

One month ago, on May 20, I predicted the end of the sucker rally in U.S. stocks, based both on the fact that U.S. stocks were overvalued from a fundamental point of view and that they were overbought from a technical point of view. At that day the S&P 500, closed at 1413.97, after having fallen 1% during the day. Yesterday, stocks closed at 1317.93, or nearly 7% lower.

Anyway, as pleasing that may be, the purpose of this post isn't merely to say "See, I told you so". I also wanted to bring attention to the fact that this downturn has differed from previous downturns in one important aspect, namely in that it has not been associated with a rising value of the yen and the Swiss franc. Indeed, between May 20 and Jjune 20, the yen actually fell nearly 3% against the U.S. dollar, while the Swiss franc rose was almost unchanged. The same relationship is essentially true if you relate the yen and Swiss franc to the euro, the pound or the Australian dollar as they have been roughly unchanged against the U.S. dollar. The New Zealand dollar is on the other hand down 1.7% against the U.S. dollar and so down also against the Swiss Franc, but even the Kiwi is up more than 1% against the yen.

Is this the end of the negative correlation between the yen and stock market movements? That may be a bit premature, but what this illustrate is that the relationship is not always reliable.

Coincident Indicators Indicate Continued U.S. Recession

The coincident indicator index from the Conference board, which is used by the NBER to determine the existence of a recession, fell in both March and April. As have been the case for every month during the last two quarters, this represented a downward revision of the initial estimate. The coincident index thus fell for every month from November 2007 to April 2008, with only a very marginal increase in January attributable to a temporary surge in power production due to unusually cold weather. Even so, the index was 0.6% lower in April 2008 compared to the peak in October 2007.

The Conference board now says the index rose 0.1% in May, but that seems highly likely to be revised down to a decline just as initially reported increases in previous months were revised to show declines. Also, both the April and even more so the May numbers for personal income were temporarily and artificially boosted by the so-called tax rebates sent out by the Federal government. As these rebates are only excluded to the extent they are classified as transfer payments and as most rebates are instead classified as tax reductions, this means that the April and May coincident indicator numbers will be artificially high. However, once they stop sending out the rebates, the index will again fall to fairer levels.

Considering that the decline has been going on for more than 6 months, it seems clear that a recession will eventually be formally declared, and that the starting point for this recession will be declared to be November 2007.

Asian Currency Decoupling

William Pesek has an interesting column on Bloomberg News about one important intra-Asian decoupling, namely on exchange rates. He points out that since the Chinese yuan ended its strict 8.28 yuan per U.S. dollar peg, it is up more than 20% versus the U.S. dollar, closing yesterday at a new high of 6.877 per U.S. dollar.

By contrast, he points out that the currencies of Asia's other 3 big economies, Japan, South Korea and India is up only a few percent since the end of the strict peg. Indeed, in all of these cases, their currencies have actually fallen in recent months, with the South Korean won being down 12.1% since its October 31, 2007 peak of 903.2 versus the U.S. dollar, the Japanese yen being down 9% since its March 18 peak of 98.23 versus the U.S. dollar and the Indian rupeeh being down 8.9% since its November 9, 2007 peak of 39.11 versus the U.S. dollar. By contrast, the yuan is up 3% since Mid-March and more than 8% since early November.

Although exporters will not like this assessment, China's currency trend is much sounder than those of the other 3 big Asian economies as it will help contain inflation and reduce the excess reliance on net exports. The problem is instead that the trend movement isn't fast enough, even though it at least in the right direction. The more recent currency movements will by contrast be problematic for Japan, South Korea and India as it will make the problems of inflation and/or excess external surpluses worse.

Swedish Financial Journalist Cite Austrian School

Gunnar Örn, journalist at Sweden's most prominent business news paper, Dagens Industri argues against inflation targeting, pointing out that it really doesn't make any sense for
central banks to respond to supply chocks with monetary movements pushing inflation in the opposite direction. He explicitly quote the Austrian school as an proponent of that view, writing

"David Davidson lanserade en annan penningpolitisk norm: Den allmänna prisnivån bör inte hållas stabil, utan tillåtas variera i omvänd proportion mot den allmänna produktiviteten....

Även den österrikiska skolan, representerad av Ludwig von Mises och Friedrich von Hayek, byggde vidare på Wicksells teorier och kom till samma slutsatser som Davidson."

Which means: "David Davidson launched another monetary policy norm: The general price level shouldn't be held stable, but should be allowed to fluctuate in opposite proportion to general productivity...

...The Austrian school, represented by Ludwig von Mises and Friedrich von Hayek, also elaborated on Wicksell's theories and came to the same conclusions as Davidson."

Now, I don't know that much about David Davidson, so I don't know how well Örn characterizes his view, but basically it's so far so good. The insanity of fighting productivity increases with money supply increases is in fact a key theme in the Timbro report I mentioned in the previous post.

My problem is instead with Örn's proposed alternative and his assessment of the current Swedish situation. He favors targeting nominal GDP, but while that is better than inflation targeting, the least distortionary monetary policy norm that a central bank could pursue is instead targeting money supply growth, and targeting it at a very low rate. Using this norm, we can see that Swedish monetary policy in fact remains too loose as M2 growth, while slowing from its peaks, remains too high at nearly 10%.

Still, it's nice to see a prominent journalist being aware of the Austrian analysis, even if his conclusions could at most be characterized as semi-Austrian.

June 30

At last a date has been set for my upcoming report for Swedish free market think tank Timbro about Swedish monetary policy. It will be released June 30, so hold on until then. Unfortunately though for readers that can't understand Swedish, it is written in Swedish, so you will not be able to read it, at least unless you want to use Google translation service, which is not particularly reliable.

Higher Costs Squeezing Profits

Interesting Bloomberg news story about stock market earnings which makes two points. First, the U.S. stock market is still very expensive as the decline in stock prices have been more than compensated by an even bigger decline in earnings. By contrast, in many other countries, including Sweden, the decline in earnings have been smaller than the decline in prices. Combined with the fact that U.S. stocks were more expensive to begin, this means that U.S. stocks should be avoided in favor of stocks in other countries.

The other point the article makes is that part of the reason for the profit squeeze is that input costs have risen more than selling prices, squeezing margins. Falling margins imply that underlying inflationary pressures are stronger than what finished products would suggest, and implies that companies will henceforth be more reluctant to accept further margin reductions and more willing to pass on cost increases in the form of higher selling prices.

Will Fed Dare Raise Interest Rates?

In the most recent week, both the dollar and U.S. market interest rates have started to rise again. The reason for this recovery is increasing speculations that the Fed might not only stop cutting interest rates, but might soon raise them again. Given the facts mentioned in the previous post, there can be little question that the Fed should do this.

However, more interesting than the question of whether they should do it is the question of whether they are likely to do it. Central bank action tends to be relatively unpredictable, compared to the effects of central bank actions once implemented, but I will still speculate about it.

It seems clear that some Fed officials, most notably Philadelphia Fed chief Charles Plosser wants to raise interest rates, as they correctly identify the very strong inflationary pressures. And while most other Fed officials are a lot less hawkish than Plosser, most recognize that inflation is indeed a big problem.

However, just because they view price inflation as a problem doesn't necessarily mean that they'll actually do something about it. The reason for that is first of all that the economy will likely continue to contract, especially after the temporary boost from the so-called tax rebates is removed. And with growth negative and unemployment rising, raising interest rates will create very negative political reactions, especially in the emerging Democratic supermajority.

The second reason is that raising interest rates would likely again flatten the yield curve, which in turn would hurt the many weak financial institutions. Of course, a quarter point hike wouldn't do much difference in that respect, but then again a quarter point hike wouldn't do much difference in terms of containing inflation either.

The only way the Fed could rein in inflation in a meaningful way would be to do another Volcker and raise interest rates so high that the economy falls into a very deep downturn. This downturn would likely be even greater than in 1981-82 because the level of debt is much higher and the financial institutions much more fragile. Faced with the choice of higher inflation and long term decline on the one hand and a painful short term purge of inflationary excesses on the one hand, the Fed seems more likely to choose the former.

It is still possible, but very far from certain, that the Fed might raise a quarter point or two later this year. However, even if they do, such modest moves from the current ultra-loose stance will not prevent inflation from getting worse.

UPDATE: Bob Novak, known for his Washington D.C. connections says the Fed will likely not raise interest rates.

U.S. Consumer Price Inflation Will Likely Rise Above 5%

The U.S. headline consumer price index has in recent months been seemingly well behaved with the monthly increase being seemingly modest and with the yearly rate staying at roughly 4%. However, as I've pointed out before, even setting aside the other manipulations, the modest monthly increases reflect massive seasonal adjustments and the stable yearly increase reflect fast increases in the previous year. However, all this will end in the coming months. With oil prices remaining sky high and with the lagged effect of the weak dollar and soaring commodity prices gradually kicking in even if the dollar does not decline further and commodity prices does not rise further, further increase in the CPI seems likely.

Meanwhile, the base effect will contribute to a dramatic increase in the yearly inflation rate. In May 2007, the CPI was 207.949 while in August 2007 the CPI was 207.917. In other words, it was unchanged. That implies that it is sufficient with a 3 month rise in the CPI of just 0.8% to push May's yearly rate of 4.2% up to 5.0%, something it will easily do. In fact, it will likely rise above that. Later in the year, it is possible but not certain that the rate might fall below 5%, but it will certainly stay well above 4% for quite some time.

No Ricardian Equivalence

While much of the news about the U.S. economy yesterday were bearish, with unemployment benefit claims reaching a new high for this cycle and with import prices soaring, the retail sales report was relatively strong.

This strength arguably reflects the fact that most of the so-called tax rebate checks were sent out that month. There are two implications of this, one with regard to the assessment of the U.S. economy and one for economic theory. Regarding the economy, this could provide some support for second quarter GDP, although this will to some extent be cancelled out by a higher trade deficit.

The implication for economic theory is, as Greg Mankiw points out, that Ricardian equivalence is again falsified. Consumers didn't seem to care very much that this extra income is only temporary and came at the price of a higher government budget deficit, and seems to have spent much of it. This result should not surprise anyone. Ricardian equivalence rests on a number of assumptions which are false, such as a general belief that the government would have to pay back its debts or that interest rates are equal to general time preferences.

Democratic Environmentalism Cause Of Higher Oil Prices

Upset about too high oil prices? Well, that is certainly justified, but you shouldn't blame the market for this. The people to blame fo this is the Democrats in the U.S, Congress who yet again blocked a Republican attempt to open up the vast offshore oil resources outside the United States for drilling.

Their arguments, repeated by their professional environmentalist backers in groups like the Sierra Club, was as usual completely nonsensical arguing that because oil has been produced in America, insufficient oil production in America couldn't be blamed for high oil prices. Which is of course complete B.S. because as anyone with even a superficial understanding of economics would tell you, increased supply will always cause prices to be lower than they otherwise would have been and as U.S. oil production is lower than a decade ago.

It is true that a decision to drill now wouldn't provide any short term relief for motorists, but this Democratic blockage -supported by a small number of Republicans, including a certain John McCain- of U.S. oil production has been going on for some time now, and hadn't they pursued this environmentalist policy before, then oil prices would have been a lot lower now. And in a few years, a decision to drill now would give relief. While we wait for that, the best solution for providing short-term relief on energy prices remain releasing oil from the so-called Strategic Petroleum Rserve, and even more importantly, ending the inflationary policies of the Federal Reserve.

Ukraine Moving Towards Hyperinflation

Sealing the deal for the Swedish interest rate hike that I predicted two days ago was yesterday's Swedish inflation number, where the EU harmonized price index rose 3.9% on a year over year basis, up from 3.2% the previous month. The other consumer price indexes showed slightly different levels, but the same dramatic increase from the month before.

But as bad as that looks, it is still far better than in some other countries. Ukraine, one of the biggest countries in Europe in terms of the size of the population and geographic area, saw its inflation rate rise to a full 31.1%. Now, that's really bad, and a dramatic increase from the 14.4% I reported about last year.

If this is not dealt with appropriately, and that means restraining money supply growth significantly, then Ukraine runs the risk of falling into a full fledged hyper inflation spiral, as the high inflation causes demand for money to fall, which in turn causes the price increases to accelerate, which in turn causes further declines in the demand in money and so on. That in turn would destroy the economic recovery produced by the commodity price boom (Ukraine is a large net exporter of commodities, both agricultural products and metals).

Did Minimum Wage Increase Cause The Increase In Unemployment?

In the recent U.S. employment report, the U.S. unemployment rate rose from 5.0% to 5.5%. As that number tends to be somewhat erratic on a month to month basis, I didn't pay much attention to it. However, if you look beyond monthly fluctuations and look at the trend over several months, then the increase in unemployment from a cyclical low of 4.4% certainly is significant and confirms the reality of a recession. And other commentators did pay great attention to it, with some Democrats jumping on this number for political purposes. Some Republican commentators have responded by attributing the rise to the increase in minimum wages implemented last year.

According to economic theory, higher minimum wages should all other things being equal increase unemployment as it prices out workers with low productivity. There are however two cases where it won't result in higher unemployment. One case is the so-called monopsony scenario where the employment of new workers would compel employers to raise wages for existing workers, causing the marginal cost of labor to exceed wages. A minimum wage above existing wage levels but below the marginal cost of labor would imply that even as existing workers get more paid, employing new ones would be cheaper. The other case is when minimum wages are so low that no workers get affected by it. For example, if there was a minimum wage of 10 cents per hour and it was raised to 15 cents, the number or workers losing their jobs from this increase will be approximately zero.

The first scenario of monopsony doesn't seem very applicable to the real world. It is relatively rare that new employees get better paid than previous employees had before, and even in the cases when they do, the employer can usually get away with it. The other scenario however seems to be closer to the truth. The new minimum wage of $5.85 is so low that very few workers are affected by it in either a positive (higher pay check) or negative (losing their jobs) way. Even assuming government inflation statistics does not underestimate inflation, the real value of the minimum wage is more than 30% lower than in 1980, and is roughly 50% lower than in for example the U.K., France and Australia. And that is the $5.85 minimum wage we're talking about, the $5.15 minimum wage is of course even lower. While the increase may have destroyed a few jobs, we are talking about very few, at most a tenth of a percent or so.

This is confirmed if we look at the pattern of job losses. Most jobs have been lost in manufacturing and construction, two sectors where pay is so high that virtually no jobs are affected by the minimum wage. By contrast, leisure and hospitality, the sector where pay is lowest and so the sector most likely affected by the minimum wage, the number of employed workers is actually up roughly 2% compared to last year. Even if that number is somewhat inflated by the flawed birth death model, it seems clear that the sector is one of the best performing. All of this suggests that the minimum wage increase have been only a negligible factor behind the jump in the unemployment rate.

This should of course not be seen as a defense of the minimum wage increase. The reason the increase has resulted in so few job losses is because it affects so few workers, which of course also means that only very few workers have experienced higher take home pay. But these results do indicate that the increase in unemployment is cyclical, which in turn suggests that the blame for the higher unemployment rate should be placed on the people responsible for the current downturn, which is to say first and foremost Greenspan and to a lesser extent also Bernanke.

Swedish Riksbank Signal Rate Hike, Phases Out Core Inflation Target

The Swedish Riksbank today signaled that they would no longer target the Swedish version of core inflation, but that they would target all-items price inflation. Sweden's core inflation measure was somewhat different from that in other countries in that it excluded the effects of consumption tax changes and mortgage interest, and not food and energy. Personally, I always found this core measure to be more justified than the American version. This goes particularly for mortgage interest, which at least in the short term rises due to central bank rate hikes -or falls from central bank cuts- making the central bank so to speak chase its own tail.

Anyway, the practical implication of this is to make the Riksbank more hawkish, as the all-items index has increased more than the core index. Considering this, the Riksbank seems almost certain to raise interest rates soon, and will probably do it more later this year. Considering that although M2 growth has slowed, it is still near 10%, that is arguably justified. It remains to be seen whether the short term negative growth effect of this tightening will be enough to push Sweden into a recession, or whether the positive effects from the government's tax- and unemployment benefit cuts can prevent this. But it seems very clear that Swedish growth will slow significantly.

Down Under Divergence

In my recent paper on carry trade I argued that interest bearing securities in countries with low real interest rates, which historically have meant Switzerland, Japan and the United States, will provide lower value for investors than interest bearing securities than in countries with high real interest rates, such as Australia and New Zealand. An argument which might sound almost trivial for some people unfamiliar with standard international economics theory, yet which is actually anything but trivial as it contradicts the prevalent uncovered interest parity theory which argues that return should be equal regardless of where you invest as exchange rate movements should cancel out any interest rate differentials.

Recently, there has been some divergence among the currencies of the two high interest rate countries which are "down under" for those of us who live in the northern hemisphere of this planet. While the New Zealand dollar has been basically flat against the U.S. dollar this year, the Australian dollar is up nearly 9%. Meanwhile, interest rates in Australia has risen relative to interest rates in New Zealand, a movement which of course is not unrelated to the aforementioned one, meaning that nominal interest rates are now higher in Australia than New Zealand. However, if one is to believe national price indexes, real interest rates remain slightly higher in New Zealand.

The reason for this divergence is that the Aussie economy so far appears to be stronger than the New Zealand economy, meaning in turn that while rate hikes appear most likely in Australia, New Zealand is likely to cut central bank interest rates.

However, it should be noted that the slump in New Zealand appears to be a wholly cyclical phenomena caused by relatively tight monetary policies. Not only are real short term interest rates at nearly 5% one of the highest in the world, but money supply growth has turned negative. M2, the money supply gauge that in New Zealand is most appropriate, has actually contracted by 3.2% in the latest year. While consumer price inflation still runs at 3.4%, it should be noted that this is first of all lower than in most other industrialized countries, and secondly that this reflects past monetary inflation, not current monetary conditions.

As the current deflationary monetary conditions means that price inflation will likely come down relative to other countries, this means that even if nominal interest rates are cut, real interest rates in New Zealand will remain far above the rest of the world, providing support for the New Zealand dollar.

In Australia, M2 isn't published by the RBA, but of the two that are published, M1 and M3, who has recently diverged. And M1 has after the recent series of RBA rate hikes slowed quite dramatically, from 13.7% in October 2007 to 3.2% in April 2008. And if you look at the latest 6 months alone, growth was negative. M3 has slowed slightly but still remains at 20%. As the correct money supply measure lies somewhere in between them, it seems likely that the actual money supply growth, and the change in money supply growth, lies somewhere in between the numbers suggested by M1 and M3. That would suggest that although monetary inflation in Australia is still too high, it is slowing. That in turn would suggest that price inflation is likely to remain high for a while, meaning that the next move by the RBA will likely be a further increase. However, with real money supply growth ultimately shrinking, this could significantly slow the Australian economy.

As I've emphasized before, that will not mean a recession unless it is accompanied by a downturn in commodity prices, which I don't see in the near future. However, with New Zealand currently purging its previous inflationary excesses while Australia still have that before it, this would suggest that although the Aussie dollar could in the short term continue to rise versus the New Zealand dollar, the medium term outlook is actually better for the Kiwi than for the Aussie.

About Employment Report

Today's employment report was in many aspects a virtual copy of previous reports, with moderate declines in payroll employment, erratic swings in household survey employment and unemployment -this month employment fell sharply and unemployment rose sharply, the previous month the opposite happened-, many jobs created in the government sector and an increasing number of imputed jobs from the fraudulent "birth-death" model, so there is really little to say about these things that weren't said in my commentary of previous months reports.

What can be said however that is new is that the report was weaker than some of the moderately bullish numbers in the previous week, and that this really takes any Fed rate hikes off the table, which is bearish for the dollar, especially considering the increased likelihood of rate hikes from the ECB and some other central banks.

Flow Of Funds & Budget Report

Last night, two key U.S. economic reports both widely ignored by most financial journalists were published.

The first report were the flow of funds report, which contained both bullish and bearish news, but mostly bearish. The one bullish item were the fact that household debt growth slowed considerably, to only 3.5% at an annual rate, the slowest in a very long time, and roughly in line with income growth.

However, because the value of household assets fell and household net worth fell even more, household leverage, i.e. their debt to asset ratio, rose to a record 20.6%, up from an upwardly revised 20.0% the previous quarter. Net worth now fell to its lowest in nominal terms since Q4 2006, and is of course even lower on a real basis and lower still on a real per capita basis. Since the bulls kept telling us that increased debt and non existent savings didn't matter because of capital gains from rising asset values, this, then the current low level of savings should be considered unsustainable even for them, assuming they are consistent (which is perhaps a too optimistic assumption).

Meanwhile, although the rate of growth in business debt slowed too, it remained quite high at an annual rate of 9.5%(The growth rate table says only 9.2%, but if you look at the actual level numbers it grew 2.3% from the previous quarter, which is 9.5% at an annual rate as 1.023^4 is 1.095 and not 1.092. Someone ought to teach these guys the principle of compound growth). Meanwhile, the growth of government debt accelerated further, to 9.9% for federal debt. The so-called rebate checks are likely to mean a sharp acceleration of government debt during the second quarter, although it might mean that household debt growth will fall further. This way, the federal government is so to speak socializing private debt.

The report also indicated that the gross savings rate fell to a new post-Depression low of 12.1% of GDP, while net savings fell to only 0.04% of GDP-also the lowest since the Great depression, except for the brief negative number following the massive capital destruction inflicted by hurricane Katrina in Q3 2005.

Meanwhile, the latest report from the Congressional Budget Office indicate that the U.S. budget deficit rose sharply in May compared to the year before. In May 2008, the budget deficit was $165 billion, up from $68 billion in May 2007. Much of this increase can of course be attributed to the sending out of the so-called rebate checks, which totaled $48 billion in May. The CBO also says that some of the remaining $49 billion increase can be attributed to calendar effects, but even excluding both the rebate checks and calendar effects, a significant increase in the budget deficit was seen.

Real federal revenues are now falling, while spending growth remain as high as ever, meaning that the budget deficit is likely to continue increase even after they stop sending out rebate checks.

Will ECB Raise Interest Rates?

ECB chief Jean-Claude Trichet today signaled that the ECB might raise interest rates next month. Considering that he explicitly sais that it wasn't a certainty and considering that they September last year cancelled a previously signaled rate hike, this does not mean that they will necessarily do it, only that they might do it. But that is not a trivial statement, considering that they've previously indicated virtually no chanse for either a hike or a cut.

Considering that both monetary and price inflation is well above their targets, there is little doubt that the ECB should raise rates, and in fact raise it more than the more quarter point they're likely to move with if they move. And their possible move now, or more correctly the inflationary pressures that motivates it, certainly confirms what I wrote from the start, namely that it was a big mistake for the ECB to cancel its planned rate hike back in September 2007. If they raise rates now they will make the future problems somewhat smaller tham if they don't do it, but it will still be too little, to late to avoid continued strong inflation in the short- to medium term perspective.

ISM Shows Rising Inflationary Pressures

The ISM surveys shows, like many other recent economic reports, showed mixed/stagnant conditions with regard to economic activity. The U.S. economy appears to be contracting, but only very moderately. One indicator that is anything but mixed however is the prices paid indicator. The extremely high value for that number of course indicates very strong inflationary pressures. Barry Ritholz has a very telling graph over this which I recommed you to check out.

No Flip-Flopping On Currencies

It took me a few days longer to do it than I had hoped, mainly due to technical difficulties with different computer programs, but now I am finally finished with the paper I mentioned a few days ago. That means I can finally resume blogging at a normal pace, or nearly normal pace.

The paper was about the phenomena known as carry trade. As I document with numbers in the paper, this strategy have over a longer period of time been a very profitable one for those who have pursued it. Although it has not always been profitable, and so is not a risk free strategy for someone with a short to medium term perspective, the fact remains that in defiance of the theory of uncovered interest parity, the expected value of such a strategy is positive and will be positive for people with a longer term perspective.

I explain this deviation from uncovered interest parity with a number of factors, most important of which are the fact that given the existence of differences in real interest rates and the mechanism supporting purchasing power parity in the goods markets, prevent the kind of massive initial real depreciation assumed by the uncovered interest parity theory from being fully realized. This theory is something which as far as I know, no one has thought of before, so it will be interesting to hear the feedback.

Anyway, returning to the finding that high interest rate currencies provide better value for investors, a question some might ask is that given that I have frequently expressed a bullish position on the low interest currencies yen and Swiss francs, does that mean that I in light of this finding will change my outlook? Actually, no. This is because first of all, this was a long-term phenomenon, and in a shorter term perspective, these currencies will likely gain from the stock market weakness I expect. Moreover, it should be noted what my bullish stance on these currencies meant and what it didn't mean. I never said that return from interest bearing securities in Switzerland and Japan would be higher. All I said they would rise. And as I also found in the paper, these two currencies have actually been the strongest over a longer term perspective and because of their lower inflation, they can be expected to remain stronger. However, because interest rates is so much lower in these countries compared to for example Australia and New Zealand, return might still be lower over a longer term, even though their currencies rise.

Finally, it should also be noted that the link between interest rates and exchange rate adjusted return was found to be stronger if you adjust interest rates for inflation than if you don't. And Swiss and Japanese interest rates aren't fully as bad as they seem in nominal terms if you adjust for inflation. By contrast, American interest rates are even worse in relative terms after you adjust for inflation, meaning that these findings give support for the bearish outlook on American securities and the U.S. dollar that I have long held.

So, in conclusion, I still think the Swiss franc and the yen will rise in both the short term and the long term. However, for someone who wants to invest in interest bearing securities, Australia and New Zealand looks most attractive, at least in the long term.