Monday, March 19, 2007

Inflation Update

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Sally Limantour

The Chinese rate hike over the weekend initially scared traders as last night the market opened lower. Initially, the dollar fell and the metals came in unchanged to a bit higher.

The Shanghai index proceeded to gain 3% which defied the typical stock market reaction to a rate hike. Are we out of the woods? Are the sub prime woes behind us? Two things that disturb me are that unlike the sell off in May/June ‘06 the break from the recent highs has been lead by the financials. One has only to look at the chart of the bank index to see the weakness.

The other issue is inflation. With US core CPI now at 2.7% y/y (well over the Fed’s 2% cap) it is hard to imagine the Fed cutting rates. I think this is what is meant when people say the Fed is between a rock and a hard place. There still seems to be a predominant belief that the Greenspan put will be adopted by Bernanke and the Fed will, once again, save the day. I think we have to look at the reality of inflation and realize the importance of food prices in particular.

Food prices are reaching high levels, particularly the category of ‘food away from home’, such as restaurants, take away food and so on. This component alone has reached its highest annual rate since April 1991. In addition food at home prices are also picking up. After reaching a low of 0.8% in May 2006 prices have now accelerated to almost 3% annual inflation. Corn prices alone have doubled and this has caused problems ranging from run away tortilla prices in Mexico to beer producers raising their prices. No longer are producers able to contain prices and have to now pass it onto the consumer.

Another aspect of the inflation picture is that whereas last years sub component prices were dominated by oil prices we now see a broader participation by other areas. Shelter remains at elevated levels, medical care inflation is back at its higher levels and apparel inflation is unusually inflationary at the current time.

In addition money supply growth is accelerating and the high level of asset prices around the world is now a problem for central bankers. Going forward
it appears we will be finding out where liquidity begins and leverage ends.

Tomorrow the FOMC begins a two day meeting and housing starts will be reported. Last January’s housing starts fell more than 14% due to the bad weather, so all eyes will be on February’s number. For today, next resistance is 1415 with strong R at 1418.75. Breaking the 1399-1401 level will clearly put the market on the defensive while rallies that hold above 1415 area should attract buying.

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