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Central Banks Inflation Quandary As Gold Prices in More US Interest Rate Cuts

Interest-Rates / Inflation Oct 04, 2007 - 12:32 PM GMT

By: Christopher_Laird

Interest-Rates Best Financial Markets Analysis ArticleWhen the Fed cut the discount and target rates by .5% they tied the hands of some other central banks who have been wanting to raise rates. From China, to the Middle East, to the EU and then Japan, each has reacted in its own way as they find they have to take into serious consideration what the Fed does.

And, as the US economy continues to weaken, prospects for further US rate cuts are in the cards, though not guaranteed on the next Fed rate decision. In fact, there is a bit of a debate going on again, that the Fed may actually pause on the next go, seeking to control damage to the USD. An interesting caveat here is that gold has already started to price in more likely rate cuts. If that does not happen, gold will drop a bit after the next Fed rate decision.

But, getting to the more current issue, the Fed's cuts are having interesting reactions from other major central banks. Overall, a weakening interest rate environment world wide is gold friendly. (A caveat here is that many interest rates are actually rising, such as Libor rates which are resisting central bank easing. Libor rates are used to set credit card, home loan, and auto loans in the US and elsewhere.)


First, the EU/ECB has been wanting to raise interest rates, as inflation becomes a bit over 2% in the EU. But, when the Fed cut, the Euro soared again. This makes it difficult for the ECB to raise rates, because the EU nations do not like the present strengthening of the Euro one bit. So far, in spite of inflation rhetoric aside, the EU has had to pause in rate hikes, lest the Euro rise more to a real pain level of 1.50 USD. This is inflationary and gold friendly.

Middle East

The Mid East oil nations are flush with cash from high oil prices, and the extra foreign exchange building up there is causing asset and stock bubbles. They have stated that they are not going to be tied to rate cuts as the Fed has cut. They need to raise interest rates to combat the trade surplus pressures on their markets. But, if they do raise, there is more movement into their currencies. So it's kind of a no win battle for them. Their primary problems are huge trade surpluses causing huge money growth there that is hard to control, as it has to be sterilized into their own currencies then finds its way into their local markets. The nations with strong trade surpluses can resist US rate cuts more easily.


Japan is seeing some deterioration in their economy, and there is some concern that deflationary pressures remain. The last thing Japan needs is a weakening US economy. The way they got a handle on their deflation of the last ten years was to export their way out of it, as they found it impossible to generate economic growth domestically during that period. The trouble is, if the US slows, that engine of growth for Japan slows down. The BoJ states they do not intend to hike rates at the present. This continues the easy money from Japan which will continue to act as a central bank of the world as people borrow money at 1% or so and throw it into markets. Gold will like that. Gold has risen quite a bit in the Yen.


China stated recently that they do not intend to be handcuffed by US rate cuts, at least not now, as they vie with a huge stock bubble. Their economic growth is still at well over 10%. They also have trouble controlling excessive lending, as private banks (underground banks) continue to lend without any regulation, as Chinese flock to various bubbles there. In addition, their interest rates around 6% are way too low to slow an economy supposedly growing at a 12% rate, and has money growth in the range of 18% as $billions of trade surplus come in and have to be washed into local currency. China has out of control money growth because of this. See Richard Duncan's seminal book, The Dollar Crisis, on how USD trade surpluses lead to out of control domestic bubbles and crashes, and how impossible it is to control that phenomenon. The Middle East has many of the same issues with excess foreign exchange coming in and causing bubble pressures.

All of these pressures of a weakening interest rate environment led by the US (central bank wise) lead to bullish gold pressures. This is especially true considering that lower interest rates by the Fed and the BoJ (easy money exhibit number one for the last ten years) leads to excessive money growth world wide, not just for their own currencies.

Competitive devaluation

As one major nation cuts interest rates, their currency falls, and that puts pressures on their trade partners. A perfect example of this is the USD/Euro situation. Prior to the US cutting the discount and target rates by a half percent, the USD was in the range of the 130s to the Euro. Right after, the rate shot up to the 1.40s and that is a pain threshold for the EU. Already, their export prices are rising. The governments and financial institutions and their industries are screaming for relief. As a result, there is significant pressure for the EU to at least halt their efforts to raise interest rates (Euro bearish). This is a manifestation of competitive currency devaluation forces. As the USD falls below 80 on the USDX (US dollar index basket of currencies heavily Euro weighted) the Euro rises unless the EU can reduce interest rates along with the USD.

China has similar problems with inevitable Yuan/RMB strengthening if they do not cut rates along with the US (they cannot, inflation is getting out of hand there).

By Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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