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Analyst report
Why on earth would the US slash rates when inflation is rising?
April 7, 2008
Brendon Lau, ShareAnalysis
Rising inflation is afflicting every major economy but the response from central banks around the world has been varied. While the issue of economic growth (or lack of) is a prominent and well-publicised factor in the divergent stand of these banks on interest rates, understanding the sources of inflation could yield clues on the future direction of monetary policy.
Since the start of the year, the US Federal Reserve (Fed) has slashed interest rates by 200 basis points (2%) to 2.25%. The market is expecting the Fed to cut rates further. Meanwhile, interest rates in the euro zone look set to remain on hold in the near term, as Australian interest rates maintain their upward bias.
Although inflation is running uncomfortably high in practically every economic zone, the sources of inflationary pressure are not exactly the same. There are generally two distinct sources of forward inflation: demand-driven pull inflation and cost-driven push inflation.
The demand-pull inflation is caused by an overall increase in demand for limited goods and services. This rise in demand can be caused by consumer and government spending. You may remember the "weight-of-money" argument used to describe the bull rally of yesteryear. The argument would be a good analogy for this source of inflation.
Cost-push inflation is used to describe the rising cost of production that eats into profit margins. Rising prices of materials, wages and taxes have a direct impact on this source of inflation.
The problem is that interest-rate hikes do not always have an equal effect on capping pressure from both sources of inflation, particularly in this current environment. While cost-push inflation is fairly universal, considering the sharply escalating base metals and energy prices, demand-pull inflation is not, and interest rates are believed to have greater impact on the demand-side of the inflation problem.
However, part of the worry surrounding the US economy is the lack of consumer demand as households cut spending on the back of tumbling home values and the waning employment outlook.
Consumer sentiment in Australia stands in sharp contrast to the US and the Reserve Bank of Australia (RBA) has warned on a number of occasions about the risks of rising inflation from burgeoning demand, although demand has tapered off a little in more recent times.
So is the Fed right to have slashed interest rates in the face of high inflation? Possibly, as US inflation is largely stemming from rising commodity prices, an area over which the Fed has little direct control. To do nothing could send the US spiralling into an extended economic slowdown.
But some analysts blame the weak US dollar on the Fed and the faltering greenback has played a big part in driving commodities higher over the last few months. Before one gets caught up in the blame game, it is important to note that the connection between the US dollar and commodity prices is not always this strong.
Even if the US dollar does strengthen, metals and energy prices may not come down for long due to strong underlying demand. Interest rates being called a "blunt instrument" against inflation is certainly an apt description.
Brendon Lau is the editor of ShareAnalysis, a premium retail investment service offered by Aegis Equities Research. Click here for your free trial.
More articles from this edition of CompareShares:
Stocks: Aussie stocks to win & lose from a rising AUD/USD
Analysis: Rudd meets Bush amidst bleak outlook for global economy
Stocks: Stock of the week – Macmahon Holdings
US: Why on earth would the US slash rates when inflation is rising?
Gold: Recent gold sell-off nothing for bulls to worry about
Expert Panel (options): Should I buy options that are in the money or out of the money?
CFDs: Top ten CFD stocks for the week
Rich list: Australia's richest lose $5b in 3 months
Opes Prime: Travel ban on Opes Prime boss extended
Sub-prime: Subprime doesn't mean doom for Asia
Please note that CompareShares.com.au simply publishes analyst reports on this page. The publication of these reports does not in any way constitute a recommendation on the part of CompareShares.com.au. You should seek professional advice before making any investment decisions. |
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