Recession Obsession Overlooks Threat of Inflation

FedEx to Raise Overnight U.S. Shipping Rates 4.9% Beginning Feb. 1 -- Dow Jones News Service, Dec. 27, 2000.

AT&T is Raising Cable TV Rates -- St. Louis Post Dispatch, Jan. 3, 2001.

AOL Fee Hike Possible -- Dow Jones News Service , Jan. 31, 2001

Forecast for This Summer's Gasoline Prices: High Again -- The Wall Street Journal, Feb. 1, 2001.

SAN FRANCISCO -- After scrounging about to find those headlines, I can confirm what you probably already knew: It's a lot easier to find indications of declining prices and slowing economic activity. The latest being today's National Association of Purchasing Management's index, which fell to 41.2 in January, its lowest level since March 1991.

The current consensus on Wall Street is that the recession -- whether already under way or about to hit -- will be short-lived and not terribly deep. But with the NAPM report joining a long line of economic indicators pointing to deepening economic malaise, perhaps that view will prove overly optimistic.

Yet for the purposes of this article (fulfilling a promise made Tuesday), consider the alternative: that the Federal Reserve's aggressive rate cuts in January, and prospects for more, in combination with tax cuts, could reignite the economy and revive inflation.

Sound fanciful? Clearly, financial markets aren't indicating any inflation concerns. Today, the Dow Jones Industrial Average rose 0.9%, the S&P 500 gained 0.6% and the Nasdaq Composite rose 0.4%. Moreover, Treasury bonds rallied sharply; given inflation is the arch-enemy of fixed-income investors -- because it eats away at the future value of coupon payments -- bonds shouldn't rally if anyone was concerned about inflation's re-emergence.

"The people I talk with both domestically and internationally -- none of them are discussing that what the Fed is doing now is inflationary, they're much more concerned about recession," said Holly Liss, senior vice president at Fuji Futures in Chicago. "Anything could happen, but [inflation] is on a deep backburner now."

Clearly, that's the majority view. Still, nobody was too worried about recession a year ago, were they?

The Case for Inflation

"I feel like I'm in the old Soviet Union" quipped Paul Kasriel, chief U.S. economist at Northern Trust. "I looked at the inflation numbers and saw a definite pickup in 2000, but they keep telling me no, I'm wrong."

Like an exterminator listening for termites with a stethoscope, Kasriel sees (and hears) inflation under the floorboards of an economy more observers fear is in deflationary spiral. Among the concerns:

Continued tight labor markets. Expectations are that while tomorrow's employment report will show nonfarm payrolls grew less than 100,000 in January, the unemployment rate is expected to rise only to 4.1%, still extremely low by historic standards.

The annual growth rate of the core Consumer Price Index remained at 2.6% in December, its peak level of the year.

The Cleveland Fed's median CPI, which doesn't automatically exclude "volatile" sectors such as food and energy, was up 3.6% on an annual basis in December.

Money supply is increasing: At the end of 2000, annualized MZM money-supply growth was reapproaching 10%. In the past five weeks, its annualized growth has exceeded 25%, according to Hays Advisory Group.

The dollar appears to have peaked: The U.S. dollar index, a weighted measure of the greenback vs. other major currencies, is now down 7.6% from its recent high of 118.72. A weakening dollar results in higher import prices.

"I disagree inflation is contained," Kasriel said. "Toward the second half [of 2001], we are likely to see inflation become more of an issue. The Fed may have to contemplate tightening by year-end, or maybe early next year."

In addition to the aforementioned, the economist's inflation concern is based on energy prices. Yes, they appear to have peaked, but copper giant Phelps Dodge PD and other commodity producers have shuttered production because of skyrocketing energy bills, he noted. Most dramatically, Alcoa AA is reducing production at two smelters in Washington state because it can earn bigger profits reselling the electricity the aluminum giant is already contracted to receive.

Additionally, Kasriel notes capacity utilization at the nation's electric utilities and oil refineries are at the highest levels since the 1970s, suggesting there's not a lot of relief in sight.

If rising energy prices cause a decrease in overall manufacturing output -- as the NAPM data indicate is occurring -- but Fed rate cuts and prospective tax cuts prompt increased demand, Kasriel concludes higher prices are inevitable. The prospect of declining economic growth plus higher prices leads the economist to fret: "Everywhere I sniff, I get a whiff of stagflation."

Notably, the prices paid index of the January NAPM report rose to 65.7 from 62.2, even as the overall index plummeted.

Kasriel may be in the minority, but he is not alone.

Diane Swonk, deputy chief economist at Bank One Corp. in Chicago, and Michael Lewis, founder of Free Markets Inc., a Chicago-based economics consulting firm, both agree the "reflation" risk is legitimate. Both believe the Fed will be done easing sooner than expected and might begin tightening again far before most Wall Street observers are currently contemplating.

"The inflation numbers are not wonderful," Swonk said in an interview today, noting that the GDP price deflator accelerated in the fourth quarter, despite the overall slowdown reported yesterday. Similarly, while the fourth-quarter employment cost index was weaker than expected, the index grew 4.1% for all of 2000, its biggest increase since 1991.

Without denying the economy's current weakness, skeptics of the recession scenario also point to the recent decline in weekly jobless claims. Despite a rise in the most recent week, the four-week average fell to 327,000 from 335,000, the Labor Department reported today. Other evidence the economy isn't dead include the stronger-than-expected retail sales in January; yesterday's new-home-sales data; the reopening of markets for high-yield bonds and equity IPOs; and the impact of mortgage refinancing, which Merrill Lynch chief economist Bruce Steinberg estimated could save consumers around $10 billion this year (and that was before yesterday's rate cut).

Also, while much has been made about the decrease in consumer confidence, Swonk "is a big believer that actions speak louder than words."

Consumer spending rose 0.3% to $6.9 trillion in December and personal income rose 0.4% to $8.5 trillion, the Commerce Department reported today.

Finally, she noted that while layoff announcements are up sharply, actual layoffs are not. Many companies have learned after bad periods in the stock market to make announcements of large layoffs, for which they can take upfront charge-offs, Swonk said. If the economy rebounds, the companies don't have to make all the cuts, but they also don't have to rescind the accounting benefits. "By comparison their numbers look better," the economist said.

But I'm sure the folks at AOL-Time Warner AOL, Amazon.com AMZN, Lucent Technologies LU, DaimlerChrysler DCX, et al., weren't thinking along those lines.