Goldilocks Doesn't Live Here Anymore
Aaron Pressman
09/29/04 - 11:50 AM EDT
With the core consumer price index rising at a 1.7% rate over the past year and the yield on the 10-year Treasury note under 4%, inflation appears quite subdued. Then again, oil prices have doubled, other raw materials costs have gained 35% and even
Starbucks (SBUX) is raising prices.
What to make of these seemingly conflicting signals? Inflation optimists see a weak economy that can't generate enough punch to support price hikes. Pessimists see a return to 1970s-style stagflation as higher oil simultaneously feeds inflation and curtails demand.
And the real worrywarts in the crowd believe falling prices, even a Japanese-style deflationary spiral, are the primary threat and driver of monetary policy.
Indeed, when it comes to the issue of cost pressures, this is either a golden age for theorists of all stripes, or an incredibly murky, hard-to-define period. It all depends on your perspective.
The
Fed, whose perspective arguably matters most, said last week that it still sees the glass half full when it comes to price pressures. Underlying inflation is "expected to be relatively low," the Fed said, allowing the central bank to slowly increase short-term rates before the economy gets overstimulated.
But some economists question whether Fed Chairman Alan Greenspan is moving too slowly, and they argue prices will accelerate -- at least faster than what the market expects.
Investors "are now overly complacent about -- even scornful of -- inflation risks," writes Morgan Stanley economist Richard Berner. A review of bond prices indicates that investors expect inflation to remain at 1.7% or even decline, he observed Friday. Danger signs abound, including higher consumer inflation expectations, according to the University of Michigan
consumer survey, increasing operations at factories outside the high-tech sector, according to the Fed's
capacity utilization data, and the weakening dollar, which makes imports more expensive.
Over at Pimco, bond titan Bill Gross and friends have been predicting increasing inflation for months. Last week, the firm predicted that the long decline in inflation during the 1980s followed by a rally in bonds in the 1990s was ending and an inflationary period similar to the 1960s was commencing, as illustrated here.
Higher oil prices even could generate inflation without much economic growth, Paul McCulley, Pimco's chief Fed watcher, said last week on
Bloomberg television after the latest rate hike.
"An energy shock has a stagflationary smell to it and that's reality," he said. Stagflation, the scourge of the 1970s, occurs when prices rise not due to increasing economic growth but because of other factors, like the OPEC oil embargo.
There's been some debate over what the Fed was trying to signal last week with its statement that the economy had "regained some traction." Some read that as a weaker assessment that the Fed's August description of an economy "poised to resume a stronger pace." McCulley didn't see it that way: The Fed showed no signs of halting its "measured" campaign to raise rates, he said, calling the most recent statement "as hawkish as you can get."
Elephant in the Room
State Street Research economist John Balder has an explanation for why the Fed might be leaning toward letting some inflation percolate. He argues that policymakers are backed into a corner because consumers have racked up record debts. According to the most recent release from the Fed, households owe $9.7 trillion, while businesses owe $7.6 trillion and the federal government is in the hole for $4.3 trillion.
If the Fed raises rates too much to guard against inflation, then the economy will slow down, reducing the ability of consumers and businesses to pay back the loans and, in many cases, increasing the interest rates on the loans, Balder said. In Japan over the last 20 years and in the U.S. during the Depression, excessive debt and a slowing economy led to massive deflation, or falling prices.
"The Fed is hell bent on preventing what happened in Japan from happening here," the economist said. "So there is an enormous bias towards being inflationary over the next five to 10 years."
Inflation is a friendlier environment for debtors. Because the principal amount of a loan is fixed, increasing inflation nibbles away at the debt burden by reducing the future value of each payment owed. This allows for debt service without requiring a catastrophic curtailment of spending.
Jeffrey Knight, chief investment officer for asset allocation funds at Putnam Investments in Boston, agrees that the Fed is fighting harder to prevent deflation than inflation. Still, he doesn't expect much of a rise in inflation over the next two years.
Most companies have had a tough time raising prices, resulting in margin pressure at firms such as
General Mills (GIS),
Unilever (UL) and
Colgate-Palmolive (CL). Meanwhile, higher productivity makes it easier for other firms to cut costs and become more efficient instead of trying to pass along higher input costs.
"We are in a stable, low-inflation environment and nothing that's happened so far this year changes that," Knight said. Still, the Fed's strategy is to "err on the inflation side" by raising rates slowing rather than risk sliding back toward deflation.
Fund firm T. Rowe Price in Baltimore has data to back up the assertion that runaway deflation is the worst-case scenario, at least for stock investors. It compared periods of mild to severe inflation and deflation quarter by quarter, going back to 1926.
Stocks did best, averaging returns of more than 20% a year, when prices were flat to slightly falling, the firm discovered. Stocks returned above 15% when inflation rose by as much as 3%. Those environments account for just about half of the quarters studied.
Returns fell off quickly as inflation increased, and were under 5% if inflation exceeded 12%. But the only scenario that generated an average loss was during periods of deflation of more than 2.5%. Stocks lost more than 5% on average during those times.
For the record, Alan Levenson, chief economist at T. Rowe, says the economy is "on pretty strong footing" and he expects inflation will increase to as much as 2.5% next year.
Distrusting Bonds
There are plenty of investors who argue that the recent rally in the 10-year Treasury note, sending yields below 4%, indicates that inflation is contained. But while inflation is a big concern of fixed-income investors, a quick check of history shows they aren't very good at guessing where it's going. For example:
The yield dropped from 4.04% to 3.13% from the end of April to June 2003. During the rally, monthly CPI numbers showed prices dropping. After the 10-year's yield bottomed, inflation accelerated. Trailing 12-month CPI had risen by 3.3% in June 2004, the highest in three years.
The yield dropped from 5.68% to 4.16% from May to October 1998, during the Russian debt crisis. Trailing 12-month CPI, which had risen 1.5% through October 1998, was up 2.6% over the subsequent 12 months.
The yield jumped from 5.83% to 7.84% in 1994. Inflation barely budged, increasing from 2.6% in 1994 to 2.8% in 1995.
It's also said that the historically low yield on the 10-year signals that the economy is slowing, or even entering a recession.
But Legg Mason senior market analyst Barry Webb compared the 10-year yield to growth in gross domestic product going back to 1976. He didn't find much evidence to back up the conventional wisdom.
"You can make the argument that exactly the opposite is true," said Webb, who isn't part of Bill Miller's mutual fund management team.
High yields in the late 1970s foreshadowed weak growth and a recession in the early 1980s. Then, falling yields in the 1980s helped usher in two of the longest postwar expansions from 1982 to 1990 and from 1991 to 2001.
Denouement
Interestingly, almost whomever you believe about inflation, the picture isn't bright for stocks. If inflation remains low when companies can't pass on higher materials costs, profits will be increasingly squeezed. Low inflation from a weak economy isn't good for stocks either.
And if inflation starts taking off, expect the Fed to get more aggressive about raising short-term rates while the bond market takes a nose dive. That would drive up long-term rates, removing one of the greatest sources of strength in today's economy.
Greenspan is expected to retire as Fed chairman on Jan. 31, 2006, when his separate 14-year term as a Fed board member ends. His replacement can expect a short honeymoon.
