Have we turned the corner?

Forget oil and gas prices, anyone buying the basics such as milk, eggs, rice, flour or vegetables are now feeling the effects: prices are rising.

“Why are prices rising when the economy is in a slump?” That”™s the question my daughter asked recently. “A million dollar question,” was my response, “with no easy answer.” Walking away I pondered whether the Federal Reserve move of cutting interest rates for the seventh time over the past six months to ease the U.S. credit crisis and other economic woes may have had other ripple effects.

We are in the midst of one of the most challenging economic cycles in a generation. A reading of 50 is the dividing line between expansion and contraction according to the Institute for Supply Management”™s factory Index. That number fell to 48 in the month of April, from 48.6 in March, a recent survey showed. As spending in the economy slowed, so has manufacturing and just about every other economic metric. In response, the Fed has been aggressive. At the end of March, the Fed agreed to float some 29 billion of taxpayer dollars to rescue Bear Stearns Cos. from bankruptcy, and in its first extension of credit to non-banks since the Great Depression, opened up lending to Wall Street securities firms at the 2.5 percent discount rate ”“ now 2 percent. These unprecedented and courageous moves took the world markets by surprise and ended ”“ for a week ”“ the age-old debate introduced by Milton Freidman that free markets without government intervention reign supreme. More importantly, in hindsight, those moves averted a disastrous credit crisis meltdown and moved us away from the abyss.

 

Lagging effects

Other components of the markets, however, are still reeling. Despite the surprise jobs”™ report from the Labor Department on May 2^nd, which showed the jobless rate drop to 5 percent in April from 5.1 in March, versus the 5.2 percent that many economists were expecting, it”™s still the highest level in three years.

Here are some of the contributors. Wall Street banks and securities firms, hit by $309 billion in mortgage losses and write downs, have slashed 48,000 jobs in the past 10 months, led by cuts at Citigroup Inc., Merrill Lynch & Co., Lehman Brothers and Bank of America Corp, according to the Securities Industry and Financial Markets Association.

 

Merrill Lynch, the third-biggest U.S. securities firm, said on April 17 it would cut about 3,000 more jobs after the credit- market crisis forced it to write down about $6.5 billion in debt. Other job cuts mentioned in the May 2^nd report included 60,000 and 110,000 in construction and goods-producing businesses, respectively, in the month of April. The bad news is that there”™s more to come.

The good news is that employers cut fewer jobs than were expected. The surprise came in the service industries, where 90,000 jobs were added ”“ the most since December.

That one-time, better-than-expected data helped the Dow Jones Industrials Average close at its highest point, so far, in 2008. Along with the market rally came another rally of sorts; the rally of the dollar, which is a departure from the past. Empirically, there has been a correlation between the Fed actions of easing rates since September 2007, and the drop in the value of the dollar. And it was no surprise to see oil test its previous high of $120 per barrel on May 5^th as a result of the Fed rate cut of 25 basis points; again a weaker dollar. However, it”™s important to note that the dollar rally was spurred by the market anticipating a pause to rate cuts, and receiving a surprise of better job numbers. Better job numbers and any sign of consumer strength, as a trend, would mean the Fed is not only done with cutting rates, but has to start raising rates.

 

Rising prices

We have seen energy price appreciation for longer than six months and that trend will moderate slightly, but will continue. The same is true for commodity food prices, but for different reasons.

A case could be made that the Fed actions of cutting rates contributed to both higher oil and commodity prices, and a reversal in that trend, or just a pause, may have an arresting effect in the near term. First, oil or any other commodity, priced in U.S. dollars on the international market, has fetched higher prices to compensate for a weak dollar. Second, ridding that premise, higher oil prices and correlated gas and diesel prices then lead to higher transportation costs. This leads to higher prices of the transported goods. So despite the slump, that”™s the rationale for higher prices for airfare, goods and any products and services dependent on oil and its refined components.

 

Conversely, as the value of the dollar rises internationally you literally get more bang for the buck, so to speak. As a result, if the dollar rally continues, and the Fed communicates its bias to raise interest rates, we can expect to see energy and commodity food prices moderate. The only preclusion to that will be an up tick in consumer demand in two areas: a) in the case of oil and gas ”“ demand created by the driving and traveling season, which will begin at the end of May; and b) in the case of food commodity prices ”“ global demand.

 

Global effects

A tangential rationale for risings commodity food prices stems from our quest for an alternative to the U.S. dependency on foreign oil. This has led to price increases of corn and soybean which are critical components of not only the ethanol and biodiesel production, but of the food chain world-over.

With the combination of tax credits and incentives, coupled with increased demand for corn to produce ethanol, and for soybean to produce biodiesel fuels, a speculative market with higher prices for those commodities was created. Add price protection, from import tariffs, and you”™ve got the “gold rush” effect.

Moreover, if we focus on corn as the principal feed ingredient in livestock production, those higher prices are passed on through the chain. So whether it”™s diary products, poultry, meats or those crops displaced by planting larger acreage of corn, the argument is that those prices are higher than they would have been in the absence of the expansion in bio- fuel use.

Finally, the growing demand for corn and other grains like rice and flour, from emerging markets like China and India, compounds the price issue. And media reports of riots in other developing countries, because of shortages, put the demand in perspective. Consequently, a drop in oil prices at this point, may not significantly affect food commodity prices because of these shortages, hording and rationing that is budding around the world.

As we look forward to the next two months, there is one silver lining: The Economic Stimulus Benefits Package. Whether it”™s $600 or $300, for many who qualify, it will not arrive soon enough.

 

Derickson K. Lawrence is the CEO of MarketView Resources Inc., a private label banking company in Mount Vernon. Reach him at info@marketvw.com.