HOW LOW, LOW, LOW WILL INTEREST RATES GO, GO, GO?

Despite the rantings of Barry Ritholtz and other bears, inflation is going down, down, down. The situation in Canada makes the point. The strength of the Canadian Looney has made American goods about 40% cheaper. Canadians are doing their shopping in America. So much is being bought in America that Canadian stores are cutting prices sharply to hang onto any business that they can. The net result is that the CPI in Canada is running at a zero rate of inflation.

The big competition from China has caused American businesses to go lean and mean. The ones that could not make the cut have moved to where labor costs are much lower than in America. The remaining businesses are tough competitors and have a comparative advantage of one kind or another. In most cases, the products being made in America are innovative or very capital intensive. We use smarts, money and industrial robots to make things that are in great demand around the world.


It think the story of Chinese pianos says a lot. The price of pianos has been cut in half twice as the Chinese have found another thing they are capable of making cheaply. The Chinese are selling so much stuff that they must let their currency float. Over the past year, the Yuan has appreciated about 9% in value relative to the dollar. Foreign investors who purchased treasury securities a year ago, have lost their shirts. American politicians complained because foreign investors have given Americans low cost loans but the providers of the money are the ones who took a great hit when the dollar fell and fell some more. The European who diversified into US dollars for safety, has lost about 38% of his principle over the last few years!

TAYLOR RULE

John Taylor, a professor and a former member of the FOMC, developed a formula to calculate what the Fed Funds Rate should be. One can use the headline rate or the core rate of inflation as inputs. I prefer the core rate because, while food and energy costs have declined in real terms for centuries, they are volatile during the short run. They both suffer from temporary supply shocks but then they revert to their declining ways. For example, sugar prices went out the roof over the past few years as more and more sugar was used to produce ethanol. The market has turned. Producers planted more and they have gotten on "top of the market". The price of sugar has fallen 40% in recent weeks as the market place is gradually recognizing that ethanol is a poor substitute for fuel.

Anyway, using the core CPI, the Taylor Rule now indicates that the Fed Funds Rate should fall to below 3%. The pendulum is now swinging in the "other" direction. If the price of a raw material were to fall from $5.25 to $3, the $2.25 decline would represent a 43% decline from the former price. A decline in interest cost is a decline in one of the inputs of manufacturing. A drop from 5.25% to 3% is a massive "deflation".

THE MARKET IS BIGGER THAN CONGRESS

The congress is caught-up once again trying to please everyone. Representative government works because it avoids the problems or mob rule or what is also known as democracy. When there are irrational swings in public sentiment, it is up to our representatives in Washington to save us from ourselves.

A Rasmussen poll confirms that the public is currently in a deep funk. Forty-eight percent of Americans now agree with the statement that Americas best days are behind us. On the far left, Americans believe the world is coming to an end because the temperature of the earth has risen a degree over the past 50 years. On the far right, Americans believe that immigrants are here to take over.

One of the many ironies is that it was public sentiment that caused the Glasden Purchase to be scaled back. Had the public not objected, the USA would own about a third of Mexico. The compromise was for us to buy Arizona and New Mexico for a song.

Yesterday, the congress moved the farm bill another notch. Once again, special interest is fighting hard to feed off the public purse. Multi-millionaire farmers are once again being subsidized. The real shame is that these subsidies restrict the ability of the farmers to sell products in the international markets. Because government is now divided, there is hope for reason. Bush only needs a third of one house as support to stop some of the worst of the silly spending. The fact that republicans over spent when they were in control of the congress has no bearing on the spending desired by this congress. Excessive spending by government is wrong. As always, picking and choosing where to spend will remain a power politics game.

It appears that the main compromise that will come out of this congress will be to do away with the scheduled tax increases of the AMT without raising taxes elsewhere. The fact remains that the government does not need more money, it needs to be more careful about how it spends the money it has.

I believe the dollar, which made a new record low against the Euro over night, is about to make a huge turn. The price of the dollar is not in the control of the congress but it is affected by the action of the congress. The market is about to see that the congress is not going to raise taxes. The market is about to see that the FOMC is going to stimulate the US economy with lower and lower interest rates as needed. The market is going to start hearing a battle for the center of the political spectrum instead of two separate battles for those who are to the far left and to the far right. Once the politicians from each side start making their moves to the middle, the market will recognize that there is political support building to reduce the harm of Sarbane-Oxley. The good news for centrist is that Hillary is the one who has left herself the most room to move toward the middle. The republican nominee will not move so far but of course the emphasis will be directed toward the most reasonable of centrist proposals.

One key point is that the great majority of our senators and representatives have a priority of avoiding a recession during an election year. Therefore, the movement of the current congress is away from more tax and more regulation. Democrats have backed away from one boondoggle after another but there is still work to be done. Congress is supposed to adjourn in only 10 days. The government still does not have a budget. By agreeing to reduce the scheduled AMT tax without increasing taxes elsewhere, the pressure to cut goofy spending rises. Over the next 10 days, a red line will be drawn though thousands of lines in the 12 appropriations bills. A lot of earmarks will still get through but a whole lot of spending is going to be cut. Yes, the grand total accepted by Bush will be a little more than what he requested but many an ornament will have been removed from the budget Christmas Tree.

200,000 BARRELS OF OIL

The increase in oil coming from Iraq, of 200,000 barrels per day, is only a drop in the international bucket but it is an important drop. The 500,000 extra barrels coming out of OPEC is an even bigger and more important drop. The oil bubble is about to be pricked. It will still take years for nuclear power and coal power to put the heavy hammer down on the price but the current speculative bubble is long in the tooth. Mexico has almost recovered from Noel. The current price of fuel oil is causing extraordinary efforts to reduce consumption. Subsidies have been reduced for billions of people. It will be interesting to see the final energy bill from congress.

SIGNS OF LOWER INTEREST RATES

Up until recent days, export sales growth and business construction have largely offset the housing drain on the US economy and the US economy has withstood the shock of higher oil prices. The truth is that the sub prime mess and the Citi-Merrill-Bear Sterns mess have been over hyped. Still, the "bad news" has taken its toll. As mentioned yesterday, there are now more AAII Bears than there are AAII Bulls. The public has been beaten down. They are selling mutual funds and paying off debt. The next big sign we need is a slowdown in the fastest growth areas. In other words, if China's growth should slow, US interest rates should fall.

Interest rates and bank reserve requirements have been raised repeatedly in China. Most recently, regulated fuel prices were raised. The cumulative effect of past increases and the slow down of trading partners should start showing-up in the China story soon. It will only take a hint of world slowdown for oil to drop $20 per barrel and for US rates to be cut again and again.

Lower rates will solve a lot of problems. It will take time to work off the excess inventory of homes in America but the process will accelerate after a decline in rates.

EARNINGS HIT

The big hit to earnings from companies like Merrill and Citibank are large enough to take away much of the excess earnings yield of the S&P. Don't let the coming reports frighten you. The fact is that earnings soar in the years after interest rates are cut. BUY, BUY, BUY!