Inflation + weak dollar = big trouble

The rise in the price of gold to more than $380 an ounce and the apparent shift by the United States to a weak-dollar policy signal an increase in the risk of monetary instability both here and abroad.

The Federal Reserve Board’s commitment to maintain an accommodative stance based on weak labor markets and backward-looking measures of inflation suggest that monetary policy within the United States will remain too easy for too long. At the same time, the Department of the Treasury’s success in getting the Group of Seven finance ministers to call for “more flexibility in [currency] exchange rates” is likely to decrease the global demand for dollars as investors seek to avoid the capital losses associated with owning or investing in a falling currency.

Economic indicators point to U.S. growth at a 5% annual rate for the remainder of the year. Rising corporate revenues and profits also are consistent with a positive outlook. However, unexpected inflation at home, and increased monetary instability abroad, could short-circuit the recovery.

Risk No. 1: unexpected inflation. One of the pillars of our positive outlook has been a dramatic reduction in the risk of deflation. Deflation is not caused by a lack of consumer demand. Rather, it is caused by the Federal Reserve Board’s providing too little money relative to demand. When the value of the dollar rises, a single dollar can buy more goods and services. If a dollar can buy more, that means prices in general have fallen.

The continued rise in the price of gold raises the specter of an unexpected in- crease in inflation. Inflation is the opposite of deflation. It is not caused by excess demand but by a surplus of dollars relative to the world demand for dollars. When the value of a dollar falls, it can buy less. This means that prices in general have gone up. An inflationary fall in the value of the dollar is a sustained rise in the price of gold, as was the case in the United States in the 1970s.

But the Federal Reserve Board is still focused on the deflation risk of the past instead of the current rising risk of inflation. After its October meeting, the Fed indicated that it still believed “undesirably low” inflation would remain “the predominant concern for the foreseeable future,” and therefore, “policy accommodation can be maintained for a considerable period.”

As a rule of thumb, gold above $400 an ounce would signal inflationary pressures regardless of the level of unemployment or economic activity. Such a price would indicate that Fed policy remains too accommodative, just as it remained too restrictive after it raised interest rates in late 1999 and early 2000. The consequence would be a fall in the value of the dollar in the goods markets and on foreign-exchange markets as well.

Risk No. 2: a weak-dollar policy. The risk of inflation is compounded by the Bush administration’s pursuit of a weaker dollar relative to the euro, the yen and especially the Chinese yuan. The apparent motivation is to respond to political pressures regarding the continued loss of manufacturing jobs and the increase in market share of products made in China.

U.S. companies’ and employees’ adjusting to China’s entry into the world economy may be one of the dominant economic stories of the next decade, if not the first half of the 21st century. This year, Chinese imports are expected to total nearly $400 billion. U.S. exports to China, for example, have grown fivefold since 1988 to nearly $25 billion a year. Of course, to purchase the billions of dollars’ worth of goods and services from the rest of the world, China must also sell billions of dollars of goods and services to the rest of the world.

Chinese exports this year are running at about a $410 billion annual rate, putting China’s overall trade balance at a modest surplus. U.S. imports from China have grown to $150 billion a year, from $100 billion in 2000 – producing a bilateral $125 billion trade deficit. But much of that increase has displaced imports from other countries. Since 2000, the approximate $50 billion increase in Chinese imports has been largely offset by a $30 billion decline in imports from other Pacific Rim countries.

Some companies and businesses are benefiting from trade with China. The Procter & Gamble Co. in Cincinnati, for example, reports that it increased its sales to China by 25% during the 12-month period through June. Others, however, are being hurt by new competition from Chinese companies, especially in textiles, light manufactured goods, footwear and toys. Changing China’s exchange rates will not change this underlying economic reality.

While a weak-dollar policy will gain little, given the rise in the price of gold, it risks much. First, it will discourage companies and governments from holding dollar assets and, at the margin, encourage them to shift their money balances into euros and yen. A reduction in the demand for dollars will accentuate the risk of a supply/demand imbalance, which could feed into unexpected additional dollar weakness on foreign-exchange markets and higher inflation in domestic-goods markets. No jobs will be saved, but American consumers will face declining incomes as they face higher prices at their stores and supermarkets.

Second, to the extent that foreign-exchange markets become less stable and more unpredictable, the ability to engage in international trade will be reduced. When trade barriers go up, growth rates tend to slow, and living standards are put at risk.

Yuan to beat?

Finally, as long as the Chinese yuan is linked to the dollar, the dollar remains the currency of record throughout Asia. Once the link is broken, the pressure on surrounding Asian countries will be to link their currency to the yuan. A shift to a yuan-based Asian economic community would reduce dramatically U.S. economic influence in the region.

The broad retreat in equity markets evident after the G-7 communique calling for more flexibility on foreign-exchange markets is consistent with increased risk of a U.S. monetary error.

The higher valuations associated with the stock market’s strong advance in recent months also contributed to investors’ heightened sensitivity to any perception of even a modest increase in the risk to the outlook. Nonetheless, the sell-off stands as a warning that efforts to manipulate foreign-exchange markets for short-term political purposes could backfire.

Charles Kadlec is a managing director with J. & W. Seligman & Co. Inc., a New York investment manager.