**false rumor about arafat being dead**, page-3

Boone knows, I still think we will see US$60.00 a barrel, US investors like sheep, sheep mentality believe rumours like Arafat. Whats the next headline "Terrorists Go on Holidays - Xmas should be safe"..


Energy Review........................

The Big Picture: Deflating the risk of inflation - Peter Gibson

Thursday, November 04, 2004
Last week I discussed my bullish outlook for oil and other commodity prices. The obvious question arising from such a forecast is 'what about interest rates?'. You may think higher commodity prices mean higher inflation, which in turn means higher interest rates. But there are good reasons to believe this simple relationship may not be as robust as during previous inflationary periods. By Peter Gibson

The world last experienced a bout of commodity-price inflation in the 1970s, during the era of the oil-shocks. Many readers may have forgotten the world's major central banks initially cut interest rates to offset the negative impact of the rising oil price. Only after the oil price set off a wage-price spiral did they jack-up rates and dedicate themselves to fighting inflation.

Alan Greenspan, chairman of the US Federal Reserve, recently said the high oil price was affecting growth and inflation, but that oil was "likely to prove less consequential to economic growth and inflation than in the 1970s". The president of the European Central Bank also expressed concern that the effect on growth, rather than inflation, was more worrying. In Japan, after years of deflation, higher oil prices may even be a blessing, of sorts.

Many observers look to the inflationary 1970s when trying to forecast the effect of higher oil prices. But that comparison misses the many nuances of the current situation. The 1970s was characterised by the low credibility of central banks, when consumers simply did not believe the monetary authorities could do anything about inflation. Inflationary expectations thus became deeply ingrained and ultimately, self-fulfilling. Inflation targeting was not seriously adopted until 1979. Today, after twenty years of declining inflation and a long regime of pre-emptive tightening by central banks, markets are almost unanimous in believing bank rhetoric about controlling inflation. And thanks to globalisation and productivity improvements, inflationary expectations have been squeezed from most consumers and workers.

Furthermore, oil supply in the 1970s was not physically constrained. There was ample capacity; the price rises were caused by geo-political shocks, such as the Arab oil embargo and the overthrow of the Shah of Iran. Today, oil supply is constrained. Lifting interest rates to tackle commodity price inflation caused by such supply constraints would be akin to using a sledge hammer to change a light-bulb. The problem of insufficient supply is best handled by allowing the market to fix the bottleneck through normal market responses to high prices.

The extent to which central banks will increase interest rates to attack commodity-price inflation will likely to limited. They will act to prevent broader inflationary trends developing in the economy, but by-and-large, they will recognise their impotence to slow inflation caused by a fundamental shortage of a natural resource supply. The correct response will be to let the market fix the problem by substituting alternative fuels, encouraging energy conservation measures and changing demand patterns. None of this is to say investors won't be fearful of higher interest rates if commodity price inflation takes hold, only that much of the fear will be misplaced.

Central bankers will certainly be vigilant about second round effects on prices and wages following an oil price shock. But most leading central bankers have clearly said there is no need to pre-empt those effects with markedly higher interest rates. So the outlook remains extremely positive for Australia and the mining industry, with relatively low interest rates and relatively high commodity prices likely to continue for some time.

One quick comment on the recent interest rate increase in China; a large chunk of China's borrowers do not or cannot service their loans, and many state-owned enterprises see bank loans as a form of government hand-out. Increasing interest rates might look like a powerful symbol, but it won't make much difference to the economy.