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Worry Warts
Inflation? Protectionism? No — Washington won’t blow it now.


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David Malpass

Several recent developments are raising concerns about inflation and protectionism — both of which are threats to the economy, equities, and bonds. The gold price rose above $382 this week on a sharp upturn, signaling an increasing risk of inflation. But the key issue is whether Washington will allow the dollar trend to shift from stable to weak, which would drive gold substantially higher and translate into a rising inflation rate.

The spot dollar index of major world currencies shows the dollar down 3 percent since Labor Day. Currently, the dollar is off roughly 3 percent versus the euro. Meanwhile, commodity prices — excluding energy — have risen 19 percent since early May, reflecting reflation and some degree of inflation concerns.

On the protectionism front, a bipartisan bill introduced this week in the U.S. Senate called for 27.5 percent tariffs against China if it refuses to strengthen its currency — the yuan. In effect, the bill is calling for dollar weakness — or else protectionism.

In his September 5 interview with CNBC, President Bush said with regard to China: “We don’t think we’re being treated fairly when a currency is controlled by the government. We believe the currency ought to be controlled by the market and ought to reflect the true values of the respective economies.” The inference in currency markets is that this logic will lead the U.S. to a weaker dollar due to the U.S. trade deficit.

On June 26, 2002, the president stated a similar position — along with then-Treasury Secretary Paul O’Neill — that the dollar’s value is controlled by the market and depends on “whether our country can rein in spending, recover, and revitalize our manufacturing base.” The worry out there is that this position invites dollar weakness, which would be inflationary.

Some economy watchers have also interpreted Fed Chairman Alan Greenspan’s August 29 speech at Jackson Hole as another signal that monetary policy will remain loose through the 2004 election. Fed Governor Ben Bernanke’s September 4 speech, reinforcing his July 23 speech, suggested that the Fed should remain loose until the output gap is corrected, leaving open the possibility of a sharp rise in inflation.

That’s some of the evidence and the chatter. Here’s a different take on what’s going on.

The difference between inflation and reflation is clear. Inflation harms growth, profits, and equity values and occurs when the dollar moves from a normal value to a weaker, inflationary value. Reflation helps growth, profits, and equity prices and occurs when the dollar moves from a stronger, deflationary value to a normal value.

To avoid a harmful inflation and capital flight from the dollar, the Federal Reserve will likely raise its key interest rate sooner than expected, and move it higher than current market expectations. It will have to respond to U.S. growth and the mounting distortions from the current 1 percent federal funds rate. The U.S. monetary base has been rising at a 14 percent annual rate for over a month, reflecting the heavy upward pressure on the fed funds rate.

The Bush administration, meanwhile, will complain about the yuan and yen, but it won’t actually shift to a weak-dollar policy. A substantial yuan revaluation would be harmful to China and the U.S., so it is unlikely to occur. Instead, a relatively stable yuan, yen, and dollar will favor growth and trade. So, despite the rising trade deficit, protectionist legislation is not likely to move forward in the U.S. Congress.

Keep all these new worries in perspective. Washington has no reason to let the inflation and protectionism scares now underway persist or cause lasting damage to the economy and the stock market.



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