Saturday, March 15, 2008

U.S. Dollar And Inflation

The Federal Reserve has chosen to attempt to support the weakening economy and to deal with inflation later when the economy improves. One problem is inflation is already here and it doesn't seem to be weakening. Add to the mix that the Fed seems to be set on cutting interest rates again, the weakening dollar, you get a set up that makes it very difficult for commodity prices to retreat.

A look at the chart of Light Sweet Crude tells the story. As the United States' economy has slowed, expectations for global growth have been re-evaluated. Add to this the repricing of risk due to the over leveraging of financial institutions, caution has caused growth expectations to slow around the globe. That being said, looking at the price of Oil at $110, one would think that demand is sky high. It is not. Some commodities are now experiencing a disconnect from the forces of supple and demand. As the U.S. Dollar continues to weaken due to the lowering of rates and the flooding of liquidity by the Federal Reserve, as well as financing our excesses by debt, Oil and some other commodities have become a U.S. Dollar hedge. As oil and gas inventories come out here in the U.S., it is clear to see that the price of oil is not just a function of supply and demand any more. As the economy slows, and inventories build, the price of Oil should come down. This can not happen while the U.S. Dollar continues to fall.

This chart compares the price of Oil to the U.S. Dollar Index. At what point will the momentum of the Dollar's decline slow to the point to allow speculation in Oil as an ill advised hedge to be reduced? My calculations show that $111.25 is a price that could be a short term top, but that could easily be breached and prices running to $114.05 followed by $116.85. As long as the Fed is cutting rates, and becoming ever increasingly creative in bailing out financial institutions that should be left to swing in the wind, confidence in the dollar will continue to weaken.

Light Sweet Crude vs. U.S. Dollar Index

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