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Economy Slows As Oil Prices Rise — Get Used To It

Economy Slows As Oil Prices Rise — Get Used To It

Today the Commerce department reported that second quarter GDP rose at an annualized pace of only 3%, far less than the 3.7% consensus estimate. Typical of their tendency to conjure a silver lining for any cloud, no matter how foreboding, Wall Street analysts have seized instead on the seemingly benign 1.8% increase in the “core” PCI (personal expenditures excluding food and energy) as evidence of diminished inflation, while ignoring the 3.2% increase in the GDP deflator, the largest in over three years. Analysts are also drawing false inferences of economic strength from today’s higher than expected rebound in the Chicago area manufactures index, which follows a month in which that index posted its sharpest decline in thirty years. Can anyone say dead cat bounce? What is more revealing is the fact that buried with the report, the regional employment index dropped sharply, to its lowest level in a year.

Analysts are also attributing the GDP slow down to higher oil prices, which have restrained consumer spending. However, as gasoline purchase are a component of consumer spending, such price increases merely change the distribution of spending, not the amount. My guess is that the slowdown resulted from falling incomes and increasing interest expenses.

However, analysts blaming the slow down on higher oil prices had better adjust their forecasts for future growth downward, and inflation upward, as oil prices are going a lot higher from here. Today, oil prices closed up another $1.05, to a new all time record high of $43.80 per barrel. In December of 2003, during an Orange County Register round table discussion of the investment and economic outlook for the year ahead, I predicted that oil prices would rise to near $50 per barrel by the end of 2004. That prediction is looking increasingly more likely to be proven correct. Also, as recently as my July 16th commentary, when oil prices hit $41 per barrel, I predicted that oil prices would end the month between $43 -$45 per barrel. That prediction has already come true.

My accurate forecast for rising oil prices was not based on terrorism threats, tensions in the Middle East, or problems in Russia, but purely on the impact of the most inflationary monetary policy in U.S. history. As the Fed continues to create dollars, and as banks and other financial institution continue to expand credit, America is flooding the world with dollars. As oil is priced in dollars, the more dollars in global circulation, the higher the price of oil. More dollars means more demand for oil. Higher demand, without an off-setting increase in supply, results in rising prices. Also, as current Fed policy causes the dollar to lose value against other currencies, oil prices denominated in other currencies are falling. The lower non-dollar price of oil, results in greater foreign demand.

Since China has been the recipient of a significant portion of those dollars, it is no wonder that Chinese oil demand has been so strong. However, Chinese oil demand today, is only a small fraction of what it is likely to become after the Yuan is floated. Once that occurs, the value of the Yuan will rise to reflect the true productive output of the Chinese. The result will be a surge in oil demand emanating from China. As oil prices collapse in Yuan terms hundreds of millions of Chinese will then be able to afford oil that was previously too expensive. However, additional world productions will not be able to accommodate this new demand. Instead, Chinese demand will be satisfied though reduced American demand, because while the price of oil will collapse in Yuan terms, it will increase substantially in dollar terms. Because much of America’s energy needs amount to necessities, even though consumption will decline significantly, it will still be substantial, and therefore very expensive.

The only way that most Americans will be able to afford higher energy bills, plus higher interest rates, taxes, insurance, medical bills, food bills, etc, will be to dramatically reduce discretionary spending. That is why today’s weaker than expected GDP data, rather than representing a temporary slowdown, is merely a harbinger of much weaker data yet to come.

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