With share prices having recovered from the subprime-related slump and in many cases making new highs, there are doubts as to whether the major central banks still have an incentive to drop rates. However, valid reasons remain for the G7 central banks in general and the Fed in particular to deliver more rate cuts:

  • Inflation is not a problem; core inflation is very muted and has come down
  • The U.S. economy is still dealing with the deflationary debris from the bursting housing bubble which gives interest rates the leeway to move lower
  • Banks are still loaded with undesirable assets; the credit crunch continues to linger and financial markets remain volatile

With these factors in mind, inflation should continue to ease. The world economy remains in a deflationary supply-side driven boom. Unit labor costs are falling and labor markets around the world have become more flexible. Labor costs in the US, Japan, Germany and China have been declining since the mid 1990’s. These developments, together with growing global trade, are powerful anti-inflationary forces that should keep core inflation low.

In Europe, with growth softening and the euro continuing to make new highs, there is no reason for policymakers to keep hiking rates. Importantly, euro area core inflation has peaked, and the future trend is more likely to be down than up. The European Central Bank will stand pat until the euro spikes further; the Bank of England will pause; the Fed will continue to drop rates; and Japan will not hike rates anytime soon. All of these developments suggest reflation will likely dictate basic trends in financial markets.

Commodity prices will trend higher through at least the first half of 2008. The dominant theme of this decade has been a resources and commodities boom. Global liquidity, low interest rates, stockpiles of oil dollars and Chinese industrialization stand at the core of this story. Commodity prices now tend to move with the developing world’s economic cycle, particularly China’s. To this end, there are few bearish clouds. Moreover, the weak dollar and flush global liquidity conditions are supportive of commodity prices. In fact, despite a sizeable US growth slowdown and two bouts of financial market turbulence in the spring of 2006 and this summer, commodity plays held up well over the past 18 months.

Michael Ashley Schulman, CFA
Hollencrest Capital Management