Axel Merk, August 12th 2004
This article was written by Merk Investments before the Merk Hard Currency Fund was launched.

Employment growth in the US has stalled, corporate inventories are rising at alarming rates. CEOs say it's only a "soft patch" in the economy; Greenspan says its due to "transitory influences" of higher oil prices.

We disagree. Only a few weeks ago, Greenspan forecast that employment growth will accelerate, it's not a question of whether, but when. He was wrong. The massive stimulus provided by the Bush administration and Greenspan over the past couple of years has run out, and the economy has run out of steam. The next stimulus package will not be passed before the next administration is in office. Until then, the only stimulus we will get is the extraordinary multi-billion dollar cash dividend by Microsoft, some of which will find its way into consumer pockets around Christmas time, a boost to GDP by some estimates of 0.2%-0.3%.

Greenspan has acted to raise interest rates further this week. He had little choice as he has waited too long to raise rates and must get rates to a higher level, so that he can lower them down the road to provide a stimulus. Even at current levels, interest rates build inflationary pressures. Greenspan must also put a brave face on the economy, as the perception of his actions is becoming ever more important.

The inflation/deflation battle is unfolding, and it has taken a turn different from what we had seen as the most likely scenario. Over the past year, long-term interest rates have only reacted to economic growth, not to the inflationary buildup. This spring, long-term bonds collapsed, and we anticipated that inflationary forces would start to be reflected in long-term interest rates. Last week, it became apparent that both the rise, and - as of a few weeks -, the fall in long-term rates, are solely attributed to economic growth, or lack thereof. When it was confirmed last week that the economy is slowing down, long-term rates fell, the stock market fell, the dollar fell, gold rose.

While inflation is creeping up in every corner of the economy, it is not reflected in long-term interest rates. Deflationary economic forces are too strong.

We disagree with Greenspan that the slowdown is due to "transitory effects" - Greenspan and Bush have fostered enormous imbalances in the global economy, and high oil prices are just a symptom. We have a global economy that is overheated yet driving the US into recession. In Asia, artificially low exchange rates continue to cause capital misallocation and inflation, large enough to be of concern to governments there; the goods produced there are swamping the US market with cheap goods, making it difficult for US companies to compete. US companies react with caution and by investing abroad. The US consumer is exhausted and only surviving because of low interest rates. All this doesn't translate to corporate pricing power, yet a lower dollar continues to cause pressure on raw materials. The best analogy we can think of is that when a car loses traction on a dirt road, one must take the foot off the gas pedal to regain traction. What's happening instead is that Bush & Greenspan are pushing the gas pedal down all the way - and, indeed, the car is advancing, but most inefficiently, stirring up a lot of dirt; eventually, the car will spin out of control and come to a stop.

This also explains the array of mixed messages, where some businesses say they are doing great, they are hiring, whereas others are suffering. It's more than the usual re-allocation of capital to adjust to a new market environment.

Greenspan has always been late in changing course with interest rate policy. It will be no different this time. He will continue to raise rates in small increments while the economy is stalling. While we think that long-term rates will rise when inflation becomes a real concern, the market tells us that, for the time being, long-term rates will head lower, further flattening the yield curve (recessive for the economy). We will have a low-interest, low-growth environment. The clear loser in this scenario is the US dollar that has to fight the forces of an unsustainable current account deficit on top of it all.

A year ago, we believed that the most optimistic scenario to unfold would be a high-growth, high-inflation scenario. This is not happening, not with no additional stimulus for at least another 6-9 months and rising short-term interest rates.

The US housing market is topping out. In Southern California, one of the hottest housing markets, a rush of inventory has come on the market, but fewer buyers are around -- so far, prices are holding up. A collapse of the housing bubble would be a death blow to the US consumer, a consumer that was stimulated to continue spending throughout the past 10 years.

Every economic cycle unfolds differently. Just when central bankers thought they had seen it all, they are faced with new challenges. This will unfold differently from the stagflation of the 1970s, but we don't envy the winner of the upcoming election.