Premature Celebration: The Market and the Fed

Joseph Brusuelas
Merk Hard Currency Fund
Aug 8, 2008

The enthusiastic response of the market to the moderation in the price of imported oil and the Fed monetary statement is a bit overdone. It is based on the hope that inflation will moderate rather than a hard-nosed look at the pricing environment. Our Senior Economic advisor Bill Poole, who knows more than a bit about crafting a coherent Fed statement, reminded the market recently that since August 2006 the FOMC in one way or another has been signaling that they anticipate inflation will moderate in coming quarters. Yet, our core inflation forecast suggests otherwise.

Our forecast implies that the June consumer price index will show continued upward movement in both the core and the headline. On a month over month basis the headline should advance 0.5% and the year over year estimate should increase to 5.2%. Using the Fed's preferred core measures provides a similar result. The core CPI should increase 0.2 m/m and 2.4% (2.481825) y/y with a real risk of a 2.5% posting, while the core personal consumption expenditure deflator should advance 0.2% and 2.4% (2.395607) over that same period.

More unsettling is our dynamic one-year ahead forecast. Looking at the CPI the core should surge out well above 3.0% by the middle of next year and the core PCE should advance to 2.6%. While some in the market may claim that inflation roughly one half of one percent above the relative comfort zones is an acceptable price to pay for stabilizing the financial system and avoiding a deeper recession, we think that this may be discounting the upside risk to these forecasts.

Headline inflation over the next months may see some easing, if the price of oil continues to fall. That is a very big "if." However, as implied by our forecast that things may not be so quiescent inside the twin core measures. First, the liquidity that the Fed has injected into the system over the past year has not yet had its maximum impact. Monetary policy acts with long and variable lags. Once those 325 basis points of liquidity takes hold firms that have watched their once potent profit margins collapse to razor thin levels will attempt to regain some measure of pricing power. Thus the risk for core pricing in 2009 is to the upside. Sound monetary policy should always be constructed to prevent a breakout in pricing. But due to the current systemic issues in the financial system, the Fed cannot act in the timely manner that it would prefer.

Second, the economic landscape is littered with the debris of mal-investment in the housing, autos and airline industries. The inventories in housing alone will take the next few years to burn off. The supply of fuel inefficient vehicles dwarfs the sagging demand left in the consumer sector. Airlines now fly fewer miles, make fewer seats available and charge a higher price for their diminished product. Thus, the problem that economy faces is one of supply, not demand.

Once one factors in the increase in the cost of energy into the equation, what one observes is a supply shock that has forced the aggregate supply curve up and to the left. This plainly suggests that situation faced by consumers is one of higher prices and reduced supply. The accommodative policy that the Fed is currently following to stimulate demand in the aforementioned sectors will directly lead to inflationary pressures in the non-financial corporate, ex-transportation sectors. This is what is behind the debasing of the dollar and in our humble opinion not the basis for sound money.

Joseph Brusuelas
Chief Economist
Merk Investments
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©2005-2008 Merk Investments LLC. All Rights Reserved.

Joseph Brusuelas is Chief Economist at Merk Investments.

The Merk Hard Currency Fund is a fund that seeks to profit from a potential decline in the dollar. To learn more about the Fund, or to subscribe to our free newsletter, please visit www.merkfund.com.

The Merk Hard Currency Fund is a no-load mutual fund that invests in a basket of hard currencies from countries with strong monetary policies assembled to protect against the depreciation of the U.S. dollar relative to other currencies. The Fund may serve as a valuable diversification component as it seeks to protect against a decline in the dollar while potentially mitigating stock market, credit and interest risks-with the ease of investing in a mutual fund.

The Fund may be appropriate for you if you are pursuing a long-term goal with a hard currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Fund and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Hard Currency Fund carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Fund's website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Fund primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Fund owns and the price of the Fund's shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Fund is subject to interest rate risk which is the risk that debt securities in the Fund's portfolio will decline in value because of increases in market interest rates. As a non-diversified fund, the Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. The Fund may also invest in derivative securities which can be volatile and involve various types and degrees of risk. For a more complete discussion of these and other Fund risks please refer to the Fund's prospectus.

The views in this article were those of Joseph Brusuelas as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein.

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