The Fear of Wages

A day of geopolitically-motivated safe-haven buying prompted gold to its best showing in a week, on Thursday. A second battery of Iranian Shahab missile tests set the news world on edge this morning once again. This, despite recent reassurances by President Ahmadinejad that his country does not seek war. A firm US rebuke followed the tests (photos of which, some say were doctored to make it appear as if more launches were being made) but the US administration also tired to play down war fears after it issued its warnings. Israel, for its part, was to show off an airplane that can spy on Iranian activities in detail.

As the Iran story unfolded, buyers made for an upbeat day in crude oil (rising $1.28 to $137.33) and bullion (showing a $12 gain to $940 after having stalled out earlier at $945 per ounce). Aiding gold's climb today were reports that cumulative central bank sales for the sales year ending in September have only amounted to 297 tonnes. Either another 203 tonnes will hit the market over the next ten or so weeks (not very likely), or the final tally might reach perhaps 400 tonnes - indicating once again that those central banks which have wanted to sell their bullion may (in very large part) well already have done so. While we still retain apprehensions about potential one-off 'necessary' sales (Italy comes to mind), the threat that central banks pose to the market has been marginalized in recent years. Now, if only some central banks would step up to the buyer's plate... (very few, and very small takers, thus far on that front).

The US Fed and Treasury heads revealed a situation that, while not resolved, continues to point towards progress on several fronts. Assets and risks are being priced, facilities are either being extended or on stand-by as needed, and further regulation is on the horizon. Rep. Barney Frank and Messrs. Paulson/Bernanke agreed that early next year will be the time for legislative measure to be taken to expand the Fed's supervisory and influence sphere. In the interim, BNP Paribas opines that the greenback has now shifted its focus (somewhat away from oil) and is trading more on the credit crisis outlook, and is therefore looking more bullish than in previous weeks.

Credit write-downs have thus far been tallied up near the $400 billion mark and now FannieMae and FreedieMac are seen as technically insolvent (at least by former Fed President Poole). Congressional testimony by the aforementioned gentlemen disputed the findings and offered a picture of adequate capitalization for the two firms. Their share prices today did not seem to match that opinion. In the US, BofA's chief said that his bank does not need to raise additional capital or cut its dividends, and also said that he sees an economic recovery in the US - about one year from now.

New York spot bullion moved higher in the afternoon hours, quoted up $14.50 or 1.5% at $942.70 as players watched oil get closer to $138 and the greenback slipping towards 72.50 on the index. The UK central bank stood pat on rates and appeared stuck between the developing US-flavoured housing slump on one side, and the rising cost of everything, on the other. Silver climbed 15 cents to $18.26 while platinum traded $34 higher at $1988 and palladium gained $7 to $449 as the former tried (and partially succeeded in getting back to values more in line with current supply deficit reality.

The tilt, as we go into the final session of the week tomorrow has improved again, and unless some strong pro-dollar jawboning or another heavy sell-off in oil emerges. In the interim, the Dow's picked up a few points on the day, but is apparently not very eager to mirror some analysts' expectations that have the equity market up by some 25 - 30% (!) by year-end. There is too much to contend with in the "here and now."

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Our afternoon focus shifts to the dreaded wage-inflation spiral that some are pedaling real hard to avoid. Rex Nutting over at Marketwatch says the Fed does not want you to get a raise. For quite some time. More specifically:

"The Federal Reserve has signaled that it's now watching wages more than core prices as it battles to keep inflation under control, says Lou Crandall, chief economist for Wrightson ICAP, and the co-winner of the June Forecaster of the Month award from MarketWatch.

Working alongside economist Bill Jordan of Ried Thunberg ICAP, Crandall had the most accurate forecasts on 10 vital monthly economic indicators released in June. On four of the numbers, Crandall and Jordan's forecast was the most accurate among 45 economists surveyed by MarketWatch.

In an interview, Crandall said the medium-term outlook for the economy is more uncertain than usual. The rise in oil prices "has really changed the outlook," he said. The expected pickup in the second half is now very much in doubt.

The stimulus payments should give growth a temporary jolt before it settles back down to a 1% annualized rate in the second half of this year and into 2009.

With credit quality falling, it's hard to predict the bottom in the financial cycle, he said.

Crandall said he believes the Fed will keep interest rates steady for while because it'll "feel comfortable" about its forecast that inflation will moderate this year and into next year. The increasing amount of slack in the economy should bring down inflation rates, as long as wage gains don't accelerate, he said.

A recent speech by San Francisco Fed President Janet Yellen laid out the Fed's view that higher commodity prices are bad enough in themselves. But even worse would be the development of a wage-price spiral, in which workers are able to demand higher wages to offset higher prices, but only by forcing their employer to raise prices in turn for their customers. Such an inflation spiral would be devastating, Yellen said.

In the past, the Fed has looked closely at core inflation (which excludes food and energy prices in order to see broader trends) to gauge whether higher energy prices are spilling over into a generalized inflation.

Now, Crandall said, the Fed is going "beyond the core-price concept" to look directly at wages.

If wages rise quickly, the Fed will act, even it means pushing the economy over the cliff by raising interest rates high enough to kill off inflation. (emphasis - mine).

The Fed's view could be political dynamite. Hard-pressed workers must sacrifice their living standards. But the people haven't really accepted the bad news yet: We are poorer because of the surge in food and energy prices, and no one -- not Uncle Sam nor Uncle Ben -- can change that. "The only way to deal with the oil price spike is for real incomes to go down," Crandall said.

Crandall is one of the last of a dying breed of Fed watchers who actually pays close attention to what the Fed is doing in its open market operations. Once upon a time, watching market operations were the only way to know if the Fed had changed policy. Nowadays, Crandall monitors the market for participants in the repo markets and other traders in the short-end of the fixed-income markets. Crandall got his start at the Fed in 1980, working with Jordan crunching numbers for the open market desk

Earlier this year, 26 years after leaving the Fed, Crandall and Jordan, by now working for different units at ICAP, decided to collaborate again. Each of them independently produces forecasts of the high-frequency economic data, and then they talk it over before finalizing their combined forecast. Usually, they split the difference. "We look at it from different perspectives," Crandall said of their approach. The most important part of the effort is to figure out what's important and what's just statistical noise, he said. "