Rodney's Ravings
John Mauldin's Outside the Box

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Introduction

A reader forwarded the following article to me last week and suggested it might make a good Outside the Box. This week's article comes from Rodney Dickens, Head of Research for ASB Bank, New Zealand and I thank him for letting me share his thoughts with my readers. Rodney has been analyzing the fixed income markets for two decades and has some insights into the current trends in global interest rates.

Rodney refers to the US Fed as the "global custodian of inflation" and finds an interesting relationship between the Fed Funds Rate and G7 capacity utilization. He then goes on to look at China's role in inflation and the current trend in commodity prices. These factors all lead to the conclusion that interest rates will continue to go up globally and that is why it was picked for this week's Outside the Box.

- John Mauldin

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Rodney's Ravings

Are we at the start of a trend rise in global interest rates?
By: Rodney Dickens
09/27/2005

THE GRAND OLDE CENTRAL BANK OF NEW YORK

Central banks continue to do to interest rates what the Grand Olde Duke of York did to the infantry - lots of marching up the hill and down again. The first two attached charts point to a bit more marching to come by the US Fed, as it continues to play its part as the global custodian of inflation.

The first chart shows that the US Fed Funds Rate is now within about 50 basis points of the level I would expect given the current level of a key leading indicator of inflation in the major seven (G7) economies. 911 etc meant the US Fed was slower to get out of the starting blocks this time around, with my measure of G7 capacity utilization - the key leading indicator of inflation for the G7 - having had almost a year's head start on the Fed since 2003, but the Fed is now catching up.


The fit in the first chart between the Fed Funds Rate and G7 capacity utilization reflects the roll the US Fed plays as global custodian of inflation. Interestingly, there is a closer fit between the Fed Funds Rate and G7 capacity utilization than between the former and US capacity utilization.

While the US is (and will remain for some time yet) the largest economy in the world, the other major economies when combined (especially when the likes of China is included) are significantly larger than the US. From an inflation perspective, the old adage about "when the US coughs the rest of the world catches cold" can be turned around (i.e. if growth in the world economy excluding the US is too strong and results in inflation problems then the US will end up having an inflation problem, justifying higher interest rates).

The story from mid-2001 to around mid-2004 was surplus G7 (and global) capacity, reflecting in the low level of G7 capacity utilization, with the low level of capacity utilization bringing fears about "deflation" (i.e. falling international prices). Booming Chinese production and associated cheap Chinese costs of production played a part in this spare capacity and deflation story.

But the low interest rates that the US Fed (and many other central banks) employed in response to the threat of deflation have produced above average growth in the world economy, which has boost G7 capacity utilization to somewhere around an average level now. And this warrants the Fed Funds Rate being increased to around an average level, with a rate of 4-4.5% being in the ballpark of an average or neutral Fed Funds Rate. Adding to the US Fed's inclination to continue to hike the Fed Funds Rate a bit higher yet - noting "Federal Reserve Bank of Chicago President Michael Moskow said Monday there was still room for the Federal Reserve to raise interest rates" (Source: money.cnn.com) - is concern about stimulatory fiscal policy in the US (e.g. "Federal Reserve Chairman Alan Greenspan told France's Finance Minister Thierry Breton the United States has "lost control" of its budget deficit, the French minister said Saturday." - money.cnn.com).

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THE CHINA EFFECT AT WORK ON GLOBAL INFLATION

The second chart shows G7 business confidence (a good leading indicator of economic growth in the G7, and in the global economy more generally) can be a useful leading indicator of G7 capacity utilization, leading by around three months. The nudge higher in G7 business confidence over the last few months points to the possibility of further upside in G7 capacity utilization over the next few months, which would imply further upside potential for the Fed Funds Rate.


Interestingly, the rise in G7 capacity utilization since the trough level experienced soon after 911 has not matched the rise in G7 business confidence (or the associated acceleration in G7/world economic growth). The obvious candidate for explaining why the level of capacity utilization in the major G7 countries has not risen as much since 2001 as history suggests it should have is the "China effect" (i.e. the flood of cheaper Chinese goods onto the world mark has hit producers in the G7 countries and left them with more spare capacity than they would normally have for a given rate of economic growth).

To the extent that the China effect has left firms in the G7 with a lower rate of capacity utilization than normal, the threat of inflation in the G7 has been lower than normal and the US Fed has responded accordingly (i.e. US interest rates are still low relative to the sort of levels achieved during previous cyclical upswings).

Unfortunately, growth in Chinese demand for resources - to a large extent associated with demand for input for Chinese exports, but increasingly also associated with growth in Chinese consumer spending - is also playing a key part in rising global commodity prices. The third chart shows my measure of global commodity prices - covering commodities in the five main commodity groups - and the same measure but excluding the energy group, both measured in US dollar terms.


In US dollar terms the global commodity price index is through the roof, with this rise in commodity prices filtering through to high US and global commodity prices over the next 12-24 months. However, even the commodity price index excluding energy prices is around previous peak levels when measure in US dollar terms (i.e. we are experiencing a generalized boom in commodity prices and not just an energy-related one).

Part of the increase in these two measures of global commodity prices over the last couple of years have been driven by a falling US dollar. The last chart shows my all commodity group global commodity price index in both US dollar terms and world price terms (effectively a currency-neutral measure of prices). It clearly shows that even extracting from the impact of a falling US dollar, we are experiencing a boom in global commodity prices on a scale not seen in the last 20 years.


There must be some parallel between the increase in global commodity prices we have seen over the last several years and the boom in commodity prices in the 1970s that preceded are broad-based global inflation problem. The obvious parallel is the role played by interest rates and fiscal expansion. Low interest rates and expansionary fiscal policies played a keep part in fueling excessive global demand in the 1970s that first showed up in booming commodity prices - the boom in commodity prices in turn playing a part in spreading the strong economic growth to commodity exporting countries - while they are playing a part in proceedings now.

So while China has been playing a part in keeping down global inflation by increasing supply, especially increasing the stock of productive capacity around the world, it is now starting to play an important part in fueling world demand. And the extent of the rise in commodity prices in recent years rings warning bells about the more general inflationary implications of the stronger demand.

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THE END OF THE LOW INTEREST RATE ERA?

When viewed in the context of the potential threat to global inflation from the boom in commodity prices, it should be no wonder that the US Fed hiked the Fed Funds Rate to 3.75% this month despite the devastation of Hurricane Katrina, and there should be no surprise that there is talk of further hikes to come.

In associated news, the US dollar gold price surpassed US$460 per ounce in recent weeks for the first time since 1988. The gold price can be a barometer of inflation risks (i.e. the risk of the real value of paper money being undermined by rising prices). So there is good reason to fear that we have left the threat of global deflation behind and are now entering a period of rising global inflation. The supply-side of the China effect may limit the upside in inflation for some time, but the demand-side of the Chinese effect will keep building.


It is quite possible that the trend fall in global interest rates that started in the early 1980s (when interest rates peaked in response to high global inflation) has ended and we are looking down the barrel at a trend rise in interest rates over the next decade - albeit with cycles along the way as central banks do what they do best (i.e. march interest rates up the hill, just to march them back down again). If so, the global property boom (that New Zealand is playing its part in) is at threat.

Conclusion

I hope you enjoyed the article by Rodney Dickens and I look forward to reading more of his analysis in the future.

Your watching The Fed raise rates analyst,


John F. Mauldin
johnmauldin@investorsinsight.com

Disclaimer

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Posted 10-10-2005 2:14 AM by John Mauldin
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