Oil hits US$146 per barrel, US economy sheds 62 K jobs, US services inflation rises, US shares recover some of recent losses.

European Central Bank (ECB) raises interest rates, sticking to orthodoxy despite rising oil and food inflation and Euroland's chronic stagnation.

Its all happening folks.

Anatole Kaletsky makes the point that oil at these prices will be very damaging to the global economy  and that it is overdue for the west to wean itself off oil.

(One could make a point about it being Independance Day, but we resist!)

Trouble is, we've had several previous warnings and have not done a lot.

Now geopolitical and environmental issues add to the economic issues to make a powerful case for change.

Professor Garnaut presented his Draft Report today, and we were there.

Our take on his thinking is here.  In short, he has laid down the challenge for our political leaders.

The heat now moves to the Rudd government.

The challenge of climate change is 'Rudd's GST' and we are about - finally - to find out whether he is fair dinkum.

'This week the OECD announced that consumer prices for all items in its 30 member countries increased by 3.9% in May compared with a year earlier, the highest rate since 2001. Energy and food prices are the main contributors, rising by 14.6% and 6.1% respectively in May. If these are excluded, the rise in prices is a far more moderate 2.1%.'  (The Economist).

 In April of this year I asked whether inflation targeting was dead or required suspension while conditions normalised.

'... Australian economic policy, and that of other inflation targeting nations, is at risk of causing an unnecessary recession. Or of abandoning inflation targeting, with all the loss of credibility that would entail. Or of explaining the suspension of inflation targeting while conditions normalise.'

I rest my case.

I was told along with others such as Bernie Fraser and John Hewson I was 'seriously misguided'.

The person who pronounced this obiter dictum, Treasury Secretary Dr. Ken Henry, is now reportedly deep in a state forest somewhere tending wombats with only carrier pigeons to inform him of the deteriorating economic conditions.  Seriously misguided indeed!

Another reason to hold the fire of further rate hikes is the continued drop of asset prices.

House price deflation seems not to be finding a stopping point in the USA, where housing is in most trouble.

US share prices are suffering a fresh bout of the colliwobbles and now show the 20 % decline from the most recent peak that defines a bear market.

Shares in the USA's big three car manufacturers have fallen especially, as continual new records set for petrol prices makes it seem unlikely that traditional gas-guzzlers will return to popularity.

Bank shares are also on the nose, even in Australia where dud loans are supposedly few.

Is it sensible to keep raising interest rates when this is the situation?

As reported earlier this week, the central bankers' central bank, the Bank for International Settlements (BIS) has said that simple inflation targeting is not sensible.

'... monetary policy might be tightened even with projected inflation under control, given a sufficiently worrisome combination of rapid credit growth, rising asset prices and distorted spending or production patterns.'

What about a 'worriesome combination' of declining credit growth, falling asset prices and distorted spending or production patterns?

If it is sensible to 'lean into the wind' with rate hikes when it is a hot north wind, it is presumably sensible to lean into a cold southerly wind with cuts to interest rates.

There is of course the problem of inflationary expectations.  Are they simply reflecting the fact of inflation, including oil and food price inflation, or do they presage a round of wage hikes that would greatly add to our economic problems?

Australian consumers' inflationary expectations have rocketed up, reaching 5.9 % in May.  Glenn Stevens, still at his post it seems, will be deeply concerned at this development.  He will also note the substantial rebound in retail sales in May.

For Australia, the net effect of the bear forces and the bull forces are probably evenly balanced for the moment, hence Tuesday's RBA decision on interest rates of watchful inaction.

But the deterioration of global confidence is of great significance.

The dilemmas facing central banks keep getting sharper.

'Optimism collapses as voters fear for future' says The Oz.

This shows the voters are fully engaged with the great global debates, no matter how distantly.

They can distinguish too between style and substance.

The fact is that so far the Rudd government has scored high on the style meter and much lower on the substance meter.

Henry is under the pump today but strongly recommends the business section of The Oz.

Here there are several takes on the BIS report, including our own.

We will comment later.  But the consensus seems to be 'We have a problem Houston'.

Welcome to the new financial year!

The Bank for International Settlements (BIS) is probably the world's leading authority on global economic trends.

Its degree of courageous dispassion no doubt comes from a comfortable existance in Basel and its long tradition as the central bankers' central bank.

This year its chief economist, William White, is said to be retiring, and is no doubt keen to leave a memorable message.

It is a doozy.

'The fundamental cause of today's problems in the global economy is excessive and imprudent credit growth over a long period ...'

The world economy is near a 'tipping point' that is likely to eventually slow inflation, and may even create a severe slowdown, even a global depression that converts inflation to deflation.

Finally, this unhappy situation is due to lax monetary policy allowing an unprecedented credit and asset bubble.

Two Dow Jones writers say: 'For central bankers from around the world gathered in Basel for the BIS's annual meeting Sunday and Monday, the report made for chastening reading. Not only does it highlight the difficulty of the dilemma facing central banks -- confronted with slowing growth at a time when inflationary pressures are rising -- it also lays much of the blame for their predicament at the feet of the central banks themselves.

'High inflation rates may not ease in 2009, as expected, and central bankers need to be extra vigilant to stop inflation expectations from creeping upward ...'

As to policy, what seems to be called for is vigilence in fighting inflation: 'With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate.'

Different economies are at different points in their economic experience, however, and there is no 'one size fits all' solution.

And, far worse for the world's central bankers, is this judgment from its intellectual leader: 'Perhaps the principal conclusion to be drawn from today's policy challenges is that it would have been better to avoid the build-up of credit excesses in the first place. In future, this could be done through the establishment of a new macrofinancial stability framework, which would call for both monetary and macroprudential policies to "lean against the wind" of the credit cycle.'

The final chapter of the report discusses 'The difficult task of damage control.'

Current market turmoil is 'without precedent' in post war experience.

Excessively low interest rates led to an asset and credit boom and, inevitably (although surprising to most), the current inflationary surge.

Most experts are predicting a slowdown but there is 'an exceptional degree of uncertainty' about how severe this might be.

"Pretty bloody severe' seems to be the message, though this is intemperate language that would never be used by the gnomes of Basel.

However, why should we not use intemperate language?  We have given central bankers all they asked for - high salaries, 'independence', clear targets - and they have failed us.

Now they conclude we are in unchartered waters and no-one can be sure how bad it will be before we return to more stable times.

If, like Henry, you have been warning about all this and are entering the 'road to retirement' just as the crisis hits, you are entitled to be angry.

In responding, what seems to be needed is a 'new macrofinancial stability framework to resist actively the inherent procyclicality of the financial system.'

This means tighten monetary policy sooner and more than Australia did and tighter fiscal policy, again in contrast to an Australia that kept budget surplusses roughly constant, gave back bracket creep and allowed spending to rise far too sharply.

In addition, simple inflation targeting will not do the job: '... monetary policy might be tightened even with projected inflation under control, given a sufficiently worriesome combination of rapid credit growth, rising asset prices and distorted spending or production patterns.'

This will be not easy to recognise and lots of hard work will be needed to work out the details and implement it next time a macro boom seems to be getting out of control.

By then, of course, there will be no-one around who recalls the great monetary policy snafu of the early 21 st century except a few old pensioners in twilight homes.

Inflation is on the march, and central bankers everywhere are steeling themselves for the battle ahead.

The Economist - a great arbiter in such matters - considers the arguments.  It starts with the case for sitting tight.

'The inflationary shock is largely confined to the surging prices of oil and food. It is a relative-price effect rather than a rise in prices across the board. Core inflation, which strips out food and energy, remains tame in both Britain and America. Provided that commodity prices stabilise—something that seems overdue after the recent increases—the surge in headline inflation should be temporary.'

The US economy, which is at the centre of the developed world's policy debate, is faced with a slowing economy, and a slowing economy should reduce inflationary pressures.

Euroland is far from booming, and indeed, most of the global inflationary pressure is coming from the developing nations, especially China with its voracious demand for raw materials of every kind.

This debate parallels that on greenhouse gas emissions (gges).  Most of the increased gges in the atmosphere came as the currently developed nations industrialised, but in the future most of the increase in gges will come from developing nations.

The developed nations, so the analogy (not that of The Economist, I hasten to say) runs, are not the cause of most of the inflation, so it is up to the developing nations to put their houses in order.

But there are risks with the approach of sitting firm. 'The big worry is that both the Fed and the [European Central] Bank may lose their hard-won authority as doughty fighters against inflation, with the result that people expect inflation to rise further. Rising inflation expectations are bad news. When people think that inflation will stay low, price-setters and wage-negotiators act accordingly, creating a virtuous circle.'

On balance, the venerable mag opts to fight the risk of inflationary expectations.

'... the lesson of previous monetary mistakes is that it is less costly to prevent inflation from escaping than to recapture it. The ECB’s plan for a rate rise in July is designed to show that it means business. Unless financial markets or growth prospects take a further turn for the worse, the Fed and the Bank will need to do the same before long. Otherwise they will lose the credibility that is a central bank’s most valuable asset.'

What is recommended for developing nations is diplomatically ignored, but what is decided there will be vital to the eventual outcome.

Both in fighting inflation and fighting global warming, what is needed is a global response to a global challenge.

In both cases considerable short-term pain will be needed to avoid even greater long term pain.

Tomorrow we consider the dire dilemma faced by the board of the Reserve Bank as it faces a sharply slowing economy with rapidly accelerating inflationary expectations.

Another pretty poor day (and week) in the markets as worries abound, including oil at US$140 per barrel.

What does it all mean? - more pain to come, almost certainly.

Aussie market fell again Friday, though thankfully not to the extent experienced on Thursday night in the USA.  Overnight, Wall Street down 'only' another 0.9 %.

John Durie puts it into perspective, and the picture is far from cheery: 'THE Australian sharemarket has fallen 24 per cent since its peak last November.

'In the process, it has reduced the $958 billion created from March 2003 to last November to a balance of just $595 billion now.

'Now, on any equation, punters are way ahead with investments in the sharemarket, even if the value of their investments since March 2003 has fallen by some 38 per cent, or $363 billion.

'Technically, a bear market is defined as being a 20 per cent fall on the index and the characteristics include falling highs and deeper lows, which means every rally stops short of previous highs and every fall from the rally sets new lows.

'This is where we are stuck, and there is no sign of it changing any time soon'.

Henry has joined the ranks of those in 'Transition to retirement' and has taken his first fateful step of running down his superannuation fund.  Together with his recently acquired senior's card, this step makes clear the downhill run gets faster now, just as a bear market takes hold.

Will Henry survive to experience one more bull market?

That is the question, Maude, and there can be no great certainty about the answer.

Catholics in the gun.

SAVE THE AIRLINES (unsolicited advice to Geoff Dixon)

Dump the male flight attendants.  No one wanted them in the first place.

Replace all the female flight attendants with good-looking strippers! What the hell -- They don't even serve food anymore, so what's the loss?  The strippers would at least triple the alcohol sales and get a 'party atmosphere' going in the cabin.  And, of course, every businessman in this country would start flying again, hoping to see naked women.

Because of the tips, female flight attendants wouldn't need a salary, thus saving even more money.  I suspect tips would be so good that we could charge the women for working the plane and have them kick back 20% of the tips, including lap dances and 'special services.'

Muslims would be afraid to get on the planes for fear of seeing naked women. Hijackings would come to a screeching halt, and the airline industry would see record revenues.

This is definitely a win- win situation if we handle it right -- a golden opportunity to turn a liability into an asset. Why didn't Bush think of this? Why do I still have to do everything myself?

The US Federal Open Market Committee decided today to keep its target for the federal funds rate at 2 percent.

'Recent information indicates that overall economic activity continues to expand, partly reflecting some firming in household spending.  However, labor markets have softened further and financial markets remain under considerable stress.  Tight credit conditions, the ongoing housing contraction, and the rise in energy prices are likely to weigh on economic growth over the next few quarters'.

The Fed expects inflation to moderate, but continued increases in the prices of energy and some other commodities and the 'elevated state of some indicators of inflation expectations', means uncertainty about inflation remains high.

Downside risks to growth have diminished, while 'the upside risks to inflation and inflation expectations have increased'. 

A reader passed the following report: 'Inflation is really picking up,' Warren Buffet said. 'Whether it's steel or oil... we see it every place. It's exploding.'

'We're right in the middle of it right now,' said Buffett, chairman of Omaha, Nebraska-based Berkshire Hathaway Inc., in an interview on Bloomberg Television today. 'I think the `flation' part will heat up and I think the `stag' part will get worse.'

The veteran investment guru said the U.S. housing slump has been a drag on Berkshire's earnings, adding that he's unsure when the economy will recover.

'It's not going to be tomorrow, it's not going to be next month, and may not even be next year', said Buffett, 77.
 
So it is time for the Fed to sit tight and hope for the best.

Dow Jones writers say the Fed could start hiking rates (in 25 basis point increments) as soon as its August meeting.

However, 'the likeliest scenario is an uneasy status quo for many months'.

In Australia, inflationary expectations have leapt to 5.9 % and the resource boom (with budget tax cuts) is likely to prevent the economy slowing to a degree that supports falling inflation.

'Uneasy status quo' is likely to be the situation here also, but there are four days to go before the RBA board meets.

Political See-saw

The political news today includes signs of a swing away from Labor in the Eastern mainland states, Queensland, Victoria and (especially) NSW.

Changes of the party of government in the states following a change Federally (or vice versa) are part of an apparent pattern in Australian politics.

We wrote in April 2006: 'The conventional explanation of this pattern is the Australian electorate’s good sense in maximising checks and balances, but there is another explanation.  Australia is a small place and there are plenty of exciting jobs in business, medicine, the law, academia, even the public service. Henry's hypothesis is that there are a strictly limited number of talented women and men who are prepared to go into politics. It requires a team of talented candidates to win elections. Any party that captures the high ground of Federal or State politics does so only when it assembles such a team, including a highly talented leader'. 

Federal Labor found its talented leader and team and got elected in late 2007.

However the rapidity of the swing in the three Eastcoast states throws cool water on our suggested mechanism. It is just too soon for talented coalition people to have entered state politics instead of federal politics.

Rather the state Labor leaders seem a bit old and tired, notwithstanding deliberate attempted refreshment by changing leaders in all cases. A 'thirst for change' is the result.

'Old and tired' seems as good an explanation as any for the demise of the coalition federally, so perhaps this is the better explanation for what we called the 'great political see-saw'.

We solicit comment on the 'see-saw' hypothesis.  Contact Henry here.

Oil edged higher, stocks edged lower, house prices plunge and consumer confidence hits another low.

This is the USA economy in action, and the gloom will spread globally.

The US Fed is meeting and is expected to end the rate cuts as inflation (excluding house price inflation) has suddenly, it seems, reappeared on the radar.

Henry's headline yesterday - 'Resource boom: inflation threat' has been supported today.

'SOARING commodity prices will push the rate of inflation borne by business to an annual pace of more than 6 per cent, increasing pressure on companies to pass costs on to consumers.'

Uren's 'bottom up' analysis is nicely forensic. 

Oil price hikes are boosting plastics and transport costs.

Iron ore hikes are boosting the cost of steel.

The costs of other building and manufacturing inputs, including copper, aluminium, concrete and cement, are also rising fast.

One might add that the rocketing costs of food, petrol and rents, as well as the massive bonuses paid to senior executives, are pushing up labor costs.

Henry heard yesterday of a small business forced to match an 18 % hike in an accountant's package or lose the bean counter to one of the big bean counting firms.

The accounting firm concerned has doubled its fee for another small business to rework something done by its predecessor.

'Take it or leave it' is the message.

Clearly the US is facing a bad case of stagflation, which will be providing a fair bit of agonising around the US Fed's august board table as we sleep.

The world is facing inflationary expectations 'unmoored' and, in places that are still booming, such as China and India, inflation has the capacity to end the boom.

Australia is an intermediate case, and its central bank will also agonise in current circumstances.

Will the horse of inflation beat the horse of a slowing economy?

That is the question for next week's meeting of the board, gentle readers.

We will be doing our agonising on the subject this weekend.

IT would be miraculous if Rio's iron ore pricing triumph didn't lead to more inflation and higher interest rates.

'SINCE the industrial revolution 200 years ago, mankind has depended on fossil fuel. The notion that this might change is hard to contemplate.'

The Economist recalls the flurry of alternative energy stories when the price of oil spiked 35 years ago.

Then the promise of fusion power and hydrogen cars came to nothing, and in any case the oil crisis subsided and the urgency went out of the search for alternative sources of energy.

However, The Economist  believes, the 35 years have not been lost.  'This time it's serious.'

'More energy is needed all round. That gives alternatives a real opening.'

And the alternatives to fossil fuels have developed to the point that they provide serious competition.

'Wind power is taking on natural gas, which has risen in price in sympathy with oil. Wind is closing in on the price of coal, as well. Solar energy is a few years behind, but the most modern systems already promise wind-like prices. Indeed, both industries are so successful that manufacturers cannot keep up, and supply bottlenecks are forcing prices higher than they otherwise would be. It would help if coal—the cheapest fuel for making electricity—were taxed to pay for the climate-changing effects of the carbon dioxide produced when it burns, but even without such a tax, some ambitious entrepreneurs are already talking of alternatives that are cheaper than coal."

On this argument, a substantial reduction in the price of oil would be disruptive, but this seems unlikely - although at some time there will be a reaction to the current overshoot.

The big difference to the seventies is the tremendous surge of demand from China and India.

This is giving Australia's economy a tremendous boost, as the stories about RIO's latest iron ore price breakthrough illustrate.

Yesterday, it was reported that The Australian Bureau of Agricultural and Resource Economics (ABARE) expected a 40 % hike in  the value of commodity exports.

Today we learn that RIO has secured an average 85 % rise in the price of iron ore exported to China.  (This was supposedly achived after considerable brinksmanship and the pressure will be repaid with interest if there ever again is a downturn in demand).

This price hike was greater than predicted by ABARE, and rarely can an economic forecast be outdated within a day of being released.

Pity the Treasurer and Treasury - it must be like being in a trench in World War I except it is money, not shells, that comes screaming in.

Booming exports should combine with subdued imports to produce a distinct cut in the dangerously high current account deficit.

This will remove one source of adverse pressure on the economy.

Other signs of pressure are likely to intensify.

Qantas flights are disrupted and the company is reported today to have stepped up its use of overseas maintenance facilities as part of its negotiation with its mainenance engineers.

Clearly the latest price action will intensify the pressure on costs in the mining industry - and as Henry reported some time ago, RIO's costs rose last year in the Pilbara by 29 %.

And there is plenty of wage pressure elsewhere, especially in state bureaucracies with state financial coffers overflowing.

It will be a miracle if the resource boom does not lead to considerably more inflation and higher interest rates  than currently expected.

Such a miracle would make Australia a real 'nirvana economy'.

**In late news from the Wall Street Journal,

'After months of negotiating with China's top steelmakers, mining giants Rio Tinto PLC and BHP Billiton Ltd. on Monday won an 85% increase in the benchmark price for iron ore, a key ingredient in steel production. The rise indicates that steel prices world-wide are likely to stay high, further fanning inflation concerns.'

It looks as though the extraordinary price increases sought by both Rio Tinto and BHP have been accepted by the Chinese buyers and the commodities boom can be expected to continue for some time yet.

A bad year is ending badly.

The best news is that pundits are stumbling slowly to the truth.

'Blame central bankers, not speculators for oil prices' writes David Uren.

Uren reports well the findings of a scholarly paper by 20 economists, including Amy Myers Jaffe and Mahmoud Amin El-Gamal, from Rice University in Texas.

The study was supported by the James A. Baker III Institute for Public Policy.

It traces the cycles of boom and bust in the oil market back to the 'dawn of the oil age' in the middle of the nineteenth century.

It contains the best analysis Henry has seen of the many dynamic interactions between monetary policy, asset inflation (including oil inflation) and goods and services inflation.

Speculation is part of the unfolding story but the study's conclusions are damning with respect to monetary policy.

'An honest assessment would look to the culpability of the world's central banks in running loose monetary policy over the past decade. The slashing of US rates over the past six months in response to recession fears raises the prospect of one last inflationary wave of excess liquidity washing into world markets'.

As to policy, 'The unregulated creation of credit bubbles, perhaps more than any other factor, has the strongest potential to drive sudden and cataclysmic crises'.

The results have included a series of bubbles and busts, including the US real estate/ exotic financial instruments bubble.

'The latter bubble is currently deflating, causing investors to flee to commodities, prices of which have reached unsustainable levels in a feedback loop that cannot continue forever'.

While the authors are cautious, one cannot avoid the conclusion that a 'sudden and cataclysmic' crisis will be part of the unwinding inflationary scenario.

The results will include financial 'contagion', a situation in which the normal benefits of asset diversification will be swamped by markets falling in snyc.

People who are very smart, or lucky, will bail out of financial assets into cash before the financial asset bubble bursts, forgoing the last part of the asset bubble.

The only other 'solution' is to ride out the storm, which is feasible if one has a reliable income and a large number of years to live.

Henry apologises for starting the week on such a gloomy note, but today's press presents a compelling picture of chickens coming home to roost.

'Oil chief rebuff on output', 'Chaos in Canberra raises fears for the economy', 'Shares to slide as crude stokes inflation fears', 'Bubble about to burst, says Soros' and 'A warning to put your affairs in order'.

On the other hand: When will the incubus of oil be off our backs?

The Economist  says this happy day is closer than we think.