Welcome to the World Weimar Republic

Worldwide inflation will continue to rise this year as essential commodity prices soar and central banks struggle to deal with the effects of the global credit crunch and the rapid devaluation of debt-based securities.

Despite the recent rate cut, the Federal Reserve Bank remains committed to its Term Auction Facility with a total of $60 billion in credit to be made available through two auctions scheduled for February 11 and February 25. According to its press release, the Fed will continue to conduct bi-weekly TAF auctions in order to “address elevated pressures in short-term funding markets”. Each one of these auctions will increase the amount of money supply present throughout the world as banks, fund managers and corporations are allowed to trade a wide variety of collateral (including subprime and other securities that are perhaps worth less on the open market) for new loans of fresh American dollars. The fact that these participants have their anonymity protected in these transactions with the Fed should be enough to make even the most casual observer concerned.

Meanwhile across the Atlantic, the European Central Bank has announced that it will extend its long term financing operations of November 23 and December 12 last year. Standing at a total value of EUR 120 billion, one has to wonder if there are any new LTFO arrangements in the pipeline, and what inflationary effect that will have.

Although excessive money supply is often a major determinant in inflation, as seen in the Weimar Republic of Germany in the 1920s, or in Zimbabwe over the last few years, commodity prices are going to have a larger role to play this year as well. The prices of food commodities and oil are two key areas that can affect inflation, as everyone needs to eat and oil remains essential to modern economies. Climate change is impacting the former as the chart for wheat prices climbs as Australia suffers from drought and corn prices climb as the crop is utilized for the green energy of bio fuel.

With oil there seems to be few possibilities where oil could be lower than in 2007, on the other hand there are strong reasons it could rise. The first consideration is that oil could lose its peg to the US dollar. Currently, inflation in Saudi Arabia and other Middle Eastern oil producing countries is at record highs as the US dollar loses value. Furthermore, the Iranian Oil Bourse is set to open on February 11. The bourse will sell oil in non-dollar currencies, with the Euro expected to be the chief currency used in the exchange. There is however, some speculation on whether the bourse will go ahead as planned after the well-publicized Internet outages in the Middle East and other areas of the world last week. The possibility of a war in Iran also needs consideration for this year. Despite the economic impact such a conflict might have, reported plans for airstrikes on Iran go back for years and America currently has a large naval fleet near Iranian waters. At the very least, political events around the Middle East should cause some spikes in oil prices in 2008.

Lastly, there is speculation that there are severe problems in OTC derivative markets, with the Bank of International Settlements putting a figure of $US 11 trillion at stake in the entire derivatives market late last year. If there is a crisis within derivative markets, possibly triggered by the subprime crisis and falling American housing market, we are likely to see more inflationary actions taken by central banks throughout the year.

Extra reading/ more sources:

The Bank Of New York Mellon: Economic update

Iran's oil bourse could topple the Dollar

Using the Internet as a weapon

Food inflation story