Dollar, oil prices hint of inflation

Two runaway trends – record oil prices and a plunging dollar – are hitting consumers just in time for the biggest retail spending season of the year.

Americans will be paying more at the gas pump and in their home-heating bills. Meanwhile, a falling dollar means that imported goods are more expensive. That includes all the toys, gadgets, and clothing people buy during the holiday shopping season.

The dollar is down for several reasons, but all reflect a more negative view of the United States relative to the rest of the global economy. Investors are selling greenbacks because of concern that inflation will rebound, uncertainty about the health of US banks, and a higher risk of recession – plus some longer-term rethinking about where to hold currency reserves.

What's going on with oil is partly the flip side of that same financial coin. Since oil is priced globally in dollars, it's typical for any big markdown in the dollar to be mirrored in a big markup in oil prices. For foreign buyers, that keeps the price of oil fairly stable. But US consumers take that adjustment on the chin.

"The terms of trade have worsened" for Americans, says Ken Mayland, who heads ClearView Economics, a Cleveland research firm. "The amount that the dollars in our pocket can buy has diminished."

A key question is whether the dollar's decline, in the long term, will be a healthy thing.

Some economists say that an overvalued dollar in recent years has made the global economy imbalanced – and that some retrenchment by US consumers is the price to pay for a return to normal.

Others say that the dollar's recent drop – and the record highs set almost daily by the rival euro – is the marketplace's warning signal that the Federal Reserve is failing to keep inflation pressures at bay. An inflating currency is generally a declining currency.

Whoever is right, the short-run fact is volatility in financial markets and a squeeze on consumers. The rising energy costs and declining dollar add a new measure of uncertainty to an economy that already faces significant challenges tied to a deep housing slump.

The directions of the dollar and oil may not persist, but in recent days they have shown considerable momentum:

•The dollar fell Wednesday to another record low against the euro, with the 13-nation European currency nearing $1.47 in value. The dollar also hit a 26-year low against the British pound.

•Gold, another barometer that investors use to gauge the dollar, is also at quarter-century highs, pushing above $840 per ounce during trading Wednesday. Gold is up more than 10 percent in the past month alone.

•Oil edged above $98 per barrel Wednesday morning, and many analysts expect the price to rise past $100 in coming weeks. After adjusting for inflation, oil is now at or near the record set in 1980 (at a nominal price then of $38 a barrel), according to the Associated Press.

•US oil and gasoline inventories fell last week, according to an Energy Department report Wednesday. Stockpiles of oil are now 8 percent below the levels of a year ago. Falling inventories have been an important factor – along with the dollar and oil-production concerns – pushing petroleum prices higher in recent weeks.

"What's happening to the dollar and gold and oil is that there is an expectation … that the Federal Reserve is going to inflate and devalue [the dollar] in order to offset the turbulence that's going on in residential real estate and mortgage finance," says Michael Darda, an economist at MKM Partners, an investment firm in Greenwich, Conn.

By his estimates, $30 to $40 of the current per-barrel price of oil should be understood as an adjustment to account for the falling dollar.

Mr. Darda views the US economy as strong enough to weather the housing downturn without falling into a recession. Thus, he says, the Fed's recent interest-rate cuts are a bad move that will come back to hurt America. When the Fed later has to raise rates to curb inflation, he says, that "could cause a recession."

Peter Schiff, president of Euro Pacific Capital in Darien, Conn., also pins blame on the Fed for being too focused on providing short-term relief - through lower interest rates – to troubled Wall Street banks.

Recently, powerhouses such as Citigroup and Merrill Lynch have announced big write-offs of bad investments tied to the housing market. A fear is that a continued fall in US home prices and a tightening of credit by banks could drive the economy into recession.

"Why else would the Federal Reserve be sitting back and watching the value of the dollar decline every day?" Mr. Schiff asks.

To Schiff, a recession would be the lesser among evils. He has written the book "Crash Proof: How to Profit From the Coming Economic Collapse," arguing that the economy needs to make a painful adjustment from credit-driven consumption toward more saving and production.

Most economists applaud recent Fed action as part of a needed effort to restore the normal flow of credit.

But the value of the dollar hints at the Fed's difficult situation. If it eases monetary policy too much, it could simply push more investors globally to buy higher-yielding (and perhaps less inflationary) currencies elsewhere.

On Wednesday, an official in China reiterated that nation's desire to diversify its large foreign-currency holdings more widely beyond the dollar.

At the same time, economists generally see recession as a genuine risk – one that the Fed generally hopes to avert.

General Motors Corp., one US bellwether, Wednesday reported a record quarterly loss – one of the worst in US history. Most of it related to one-time costs of a health insurance deal with the United Auto Workers union. But US car sales are also being hampered by the effects of the housing downturn, GM said.

"In our view, [spending by consumers] is on the precipice of experiencing its first recessionary phase since 1991," Merrill Lynch economist David Rosenberg writes in a recent analysis. As in 1991, he says, consumers face "the combination of punishingly high energy prices, weakening employment conditions, real estate deflation, and tightening credit conditions."

Yet Mr. Mayland, the economist in Cleveland, expects the overall economy to escape recession. To some degree, the recent moves in financial markets are driven by "momentum players" betting that current trends will continue, he says. The falling dollar is "a kind of payback for that period when the trade deficit was rising and we had the easy ride with the stronger dollar."

But if the dollar is now weighing on the US standard of living, other factors are working in the opposite way, Mayland says: "Today, productivity numbers came out and they came out much stronger," at a nearly 5 percent annualized pace.

That means that workers are adding more to the nation's gross domestic product with every hour they work. "That's something that raises our standard of living," Mayland says.