Inflation Picture

For me, the primary stimulants of inflation are commodities
prices and a range of key cyclical sector operating rates.
My inflation stimulus pressure gauge is essentially flat
for the past six months, suggesting little forward momentum
for inflation. As I have argued, the "core" inflation rate,
or inflation excluding volatile commodities such as energy
and foodstuffs, is overdue to show some acceleration following
the dramatic run-up in fuels prices in recent years. Nevertheless,
the inflation vanguard has slowed. Moreover, productive capacity
overall is beginning to grow a little faster.

The inflation pressure gauge remains on a high plateau, and
the recent positive bounce in oil and refined products is
putting a little stress on the financial markets. Iran, with
help from an equally belligerent Bush admin. is doing a swell
job of kiting the oil price and keeping traders in the game.
There is plenty of supply, but an abundance of fear as well,
and traders are thankful as it is keeping the oil price
up ahead of the forthcoming US hurricane season. After the
last two years, you can bet that weather.com will get a big
play as the air warms in July and August.

There is even a growing buzz on the web that the US is planning
to try and take out Iran's nuclear capacity. Understandable
given the Bush Doctrine of pre-emptive strikes when He spots
peril. And there's the low approval rating, too. Patriotism
as the last refuge of a scoundrel and all that.

Interesting stuff all, but at quite an advance to the economics
on the ground. There is a message here too for the Fed as well,
which is not to overreact to the powerful scarcity fear psychology
gripping the petrol sector.

The FOMC Decision on Short Rates

The first FOMC policy meeting under new chair Bernanke is
winding up over lunch, and their decision on rates etc. will
be announced in a couple of hours.

Most everyone out there is looking for business as usual --
a 25 basis point hike in the FFR%. Since the Fed also has a
God given right not to be psychoanalyzed, I would not presume
to say what the gang will come up with.

The customary cyclical fundamentals that are usually front
and center for the Fed are vibrant enough -- broad cyclical
expansion, rising operating rates and strong and rising
short term credit demand. there's enough rolling out there
to support a FFR% of 5.00 - 5.25% in my view, and we should
have been there already, save for Uncle Al's baby step policy
inclination.

The Fed has eased on the liquidity front since this past
autumn, but not enough to signal a policy change.

The one item in the usual mix that is of interest to me is
the mild acceleration underway in the growth of production
capacity. Over the past several months, yr/yr capacity
growth has moved up from a paltry 1.1% to near 2.0%.
The longer term trend seems to be turning up and this is
very important because, should it continue, production
supply / demand growth will come into much better balance,
and this will undercut inflation stimulus within the system.

I am hoping that Benny The Banker will step right up and
put his fingerprints all over the FOMC decision and
consequent statement rather than toodle along like a Greenspan
acolyte. We'll all see shortly.

Gold -- Not For A Cheapskate Like Me

Well, there it is, trading in a range of $550-560 oz.
Some of the pundits tell me $600 is the next stop on
a glorious upward ride. Wow, and here I am thinking
that I could eke out a decent case for gold at $450
oz. based on commercial demand / supply/ extraction
costs. I even thought it would sell off sharply over
the first four or five months of 2006. I know there
are concerns that oil supplies could be disrupted, but
when I look at that market, I can make out a good case
for oil at $40-50 bl., not $60+. No comfort there either.
looks like the same guys are in that market, too.

When I look at the gold charts, I see a sitting duck,
with intermediate term weekly MACD rolling over from very
high levels, yr/yr price momentum very high, Wilder
ADX closing in favor of internal supply. But, a
big drop has not come.

So, for now, I am consigning gold to the "out of my
league" category, to be dusted off periodically.

I do get a kick out of the gold bug websites. Not
even the more voracious Wall Street Bankers can touch
these guys for hucksterism.

A Little Trouble In Big China

China is averaging about 200 protests / riots a day.
This is not spontaneous. China's political left is
recovering after years of quiet.

Well paid workers in the eastern part of China are
leaving their country cousins in the dust. Plus,
the new running dogs of capitalism are turning the
country into an environmental cesspool and are
swiping turf the peasants once claimed.

Leader Hu has spoken of developing a "golden harmony"
that brings the 800 million Chinese who are not
sharing in China's economic development into the tent.
A very tall order.

As the NY Times reported today, the Chinese left is
starting to get its voice back, sounding strong
criticism of the country's growing imbalances in
the wake of its economic development.

Hu now has to straddle the fatcats and the peasants'
slow burn which is heating up steadily. This guy is
going to be tested right down to his new Ferragamo's.

Beijing hosts the 2008 summer Olympiad. This is planned
as Beijing's coming out party as a world capital. Losing
face in China is bad business, so 2008 should be a quiet year.
But the left will be pressuring hard for goodies through
2007.

The Chinese excel in traumatic political upheaval, and now
that the old commies are hooking up with the peasants, the
small trouble in China may well become very big trouble in the
years ahead if China fails to rapidly shift its focus from
the fatcats ball to the downtrodden.

Just one more thing that's going to heat up in the years ahead.

The US Trade Account

The LDCs and the weaker OPEC countries experienced economic
depression in the early 1980s as oil and other commodity
prices collapsed. It was a stock Kondratieff downwave that
was eclipsed from going fully global by timely major
central bank intervention, large US income tax cuts and a
relaxing of regulations regarding the writeoffs of non-
performing LDC/OPEC credits.

The US had been the lender of last resort. Now it had to
become the buyer of last resort to stave off spreading depression.
The original global rescue plan called for three locomotives to
pull the world back from the abyss: The US, Germany and Japan.
Between 1983-87, Germany and Japan welched on the deal, leaving
the US to carry the load. The strong US $ policy of 1980-85
did the trick, but the US began to run a deep trade deficit.
A weak US $ from 1985-95 reversed this situation, and by 1991-
92, the US was running a modest surplus on current account.

Powerful US economic fundamentals over 1995-2000 produced a
dramatic rally in the dollar which actually ran until 2002.
At first, both imports and US exports were strong, but export
growth faded and the trade gap again accelerated. Moreover,
it continued to grow rapidly even as the dollar tumbled from
2002-2005. The elixir to eliminate the current account deficit,
namely a weak US $, failed. Many exporters, China notably and
much of the rest of East Asia tied their currencies to the dollar,
while Europe and Canada gave up profit margin to maintain market
share.

Strong US interest in "free" trade has a long term objective.
We know as the massive baby boomer cohort passes into the
retirement years, US consumer purchasing power will moderate
very substantially. The hope is that exports will pick up
a fair portion of that slack and that countries like China
and India will eventually focus on growing their own
consumer economies.

All the countries who export to the US know that the consumer
will soon be past his prime, spending wise, and it is
Katy bar the door to sell as much into the US as they can
before demand slackens.

Only time will tell whether our policy aim will prove effective.
However, it seems to me that the next 5-7 years are going to be
difficult and risky on the trade front. Big US companies like
Dell and The Gap have large offshore production which they
distribute here. So the open market concept benefits many major
US companies. But smaller companies -- the backbone of US job
creation -- will be at increased risk as more niche markets
come under attack from abroad. On the flip side, the US is
exporting $ liquidity to the tune of nearly $800 billion a year.
Foreign currency reserves are ballooning, and the risk of
all manner of speculative excess abroad is rising rapidly.
Japan went bananas with this liquidity in its real estate and
stock markets in the 1980s and it has only been recently that
it has regained a comfortable degree of equilibrium.

When an exporter to the US locks its currency to the dollar,
it is engaging in a form of mercantilism. The US should
hammer China and the other bandits that are keeping
currencies artificially low. But it has chosen to let it all
happen so large US corporate and banking interests can prosper
abroad. This is a dumb policy that will hurt smaller
domestic interests as well as the overconfident foreign
treasurers who think they can manage mushrooming liquidity
with ease.

So we have to keep eyes on the trade sector, particularly
throughout developing Asia as the central banks out there
have yet to show their mettle.

The more one watches major US business interests, the more one
is reminded of Ike's admonition to watch that military / industrial
complex.

Stock Market -- Fundamental

S&P 500: 1274

I use three different fundamentals - based models to track
the SP500. All imply that from an empirical perspective the
S&P is reasonably valued in the range of 1280 - 1300. I
do not put too much stock in the predictive value of any
of these approaches, but use them more as a diagnostic
reference. Even then, I would not make too much out of
divergences until they exceeded 6% or so. For me, the market
looks reasonable enough now.

To summarize the output of the models, the market's rally since
this past autumn reflects a continuation of above average
earnings growth and an expanding p/e ratio to reflect a moderation
of inflation pressure which in turn has been supported by a
moderate easing of liquidity policy by the Fed as well as
continued good growth of the SP500 dividend. The key changes in
the mix since last October or so have been a step up in the
growth of the monetary base and a reduction of inflation pressure
stemming from lower fuels prices.

The risk premium of the market (earnings/price yield - 91 day T-Bill
yield) is continuing to shrink from once very high levels. Thus,
risk continues to rise, and it will be interesting to see how
the market holds up if the Fed tacks on another 50 basis points
to the FFR% over the next few months. Could be a character builder
for investors.

Yield Curve Inversion

The yield curve inverts when short maturities sport yields
above those of longer dated maturities. We have seen yield
curve inversion in the US Treasury market on a day to day
basis since late in 2005.

Historically, an inverted yield curve has been a good
indicator of an impending sharp economic slowdown or
even recession. That's because yield curve inversion is
normally a symptom of either a liquidity squeeze or a
developing credit crunch wherein banks severely restrict
shorter term lending.

We have no squeeze or crunch now. Far from it. The
broad money aggregate M-3 is up 8.4% yr/yr, commercial
and industrial loans are up 15.5% yr/yr and trending higher,
and real estate loans continue to grow. In fact, the
financial sector is generating excess liquidity
now, or more liquidity than the economy actually needs.

Now, if the Fed Funds rate gets put up above 5.25% I'd wager
that banks will begin to take notice, and may well begin to start
to ration credit modestly. M-3 growth would slow because
funding requirements would slow, and the economy would
enter the very early stage of a liquidity squeeze. Bond
yields could even go lower in such an environment because
bond players would begin to anticipate eventual recession,
lower inflation and a flight to quality.

I'm strictly guessing the Fed may cut off the push on the
FFR at 5.0-5.25% in the months ahead, up from the current
4.5% posting. I doubt the Fed wants to become a centerpiece
political issue in a critical off-election year such as is
2006.

What might be of interest is how the bond market behaves
if the Fed goes to a FFR 5.0% and signals it may well
stay there for a while. That might send bond yields
sharply higher since some players would likely conclude
they may as well shorten maturities.

Note as well that following Uncle Al's silly roller coaster
ride with Fed credit post-Katrina, the FOMC is again adding
to holdongs, thereby signalling another bit of easing.