Rising Inflation, Falling Stocks: Greenspan Stuck in a Tough Spot

Fed Chairman's Burden

SAN FRANCISCO -- Houston, Alan Greenspan has a problem. Most Wall Street economists and several of my RealMoney.com counterparts dismissed this morning's stronger-than-expected Consumer Price Index report as an anomaly -- much as they did with last Friday's stronger-than-expected Producer Price Index. But the Federal Reserve chairman isn't likely to be so nonchalant about additional evidence inflation may not be dead, after all.

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Simultaneously, however, Greenspan faces a stock market that is crying, begging, and desperately pleading for another rate cut. Despite rumors of an "emergency" Fed meeting in the wake of economic and political crisis in Turkey, major averages suffered another round of losses today. The Dow Jones Industrial Average fell 1.9% to 10,526.58, its lowest close since Jan. 12. The S&P 500 sank 1.9%, to 1255.27, its lowest since Oct. 18, 1999. The Nasdaq Composite dropped 2.1% to 2268.93, its lowest close since March 3, 1999.

As if that weren't bad enough, technical analysts say all three averages have now broken important trend lines, suggesting more weakness to come. With investor confidence rapidly declining and fears rising, it seems only another rate cut from the Fed has the power to stem the bleeding, even if only temporarily.

But today's CPI data, on top of the PPI report, on top of the robust housing market, in addition to the still-low unemployment rate, appear to put Greenspan in a bind.

Those who view the January CPI report as an outlier noted that a 17.4% increase in natural gas prices greatly influenced the 0.6% headline figure. Since gas prices have been falling recently, many market watchers took comfort that the inflation risk has past. Several observers noted forward-looking inflation indicators such as the CRB/Bridge Futures Price Index, which fell 0.9% today, and the Journal of Commerce Index of commodity prices have been tumbling lately, indicating inflation remains well contained.

"Like PPI, the market was ready to dismiss the CPI gains as due to [the] extraordinary increase in natural gas," said Anthony Crescenzi, chief bond market strategist at Miller Tabak in Chicago. "But I do think there is a camp that believes this [inflation issue] will at some point either slow the pace of rate cuts or stymie them completely."

Crescenzi, for one, does not think the inflation risk (real or imagined) will prevent the Fed from easing short term. But he does believe the long-term forces that kept inflation down in the 1990s are abating. In addition to the obvious example of energy prices, increases in health care costs, import prices and wages all "bode poorly for the inflation story" longer term, he said.

Given the Fed's current focus is to combat weakness in the economy and the drop in consumer confidence, near-term rate cuts are likely, the economist continued. "But if the economy rebounds, the Fed will have inflation concerns foremost in their mind, and will be quick to change their policy stance, at least behind the scenes."

Paul Kasriel, chief economist at Northern Trust in Chicago, has long been in the camp that says inflation is on the rise. In a report today, he noted the core CPI -- which excludes food and energy --- increased at an annual rate of 2.9% for the three months ended in January, a 50 basis-point jump vs. the three months ended October.

"The composition of the January CPI report, particularly the 0.3% increase in the core CPI, complicates the outlook for monetary policy," the economist wrote, while acknowledging additional economic data will determine whether the Fed eases by 25 or 50 basis points at its March 20 meeting, presuming it does ease.

Even Richard Berner, chief U.S. economist at Morgan Stanley Dean Witter, who does not believe inflation is a threat, said: "The Fed has clearly signaled at this point they believe that the worst of the decline in growth is over. There's a belief we may well skirt a recession, and if that's the case, they can afford to be more measured in the pace of easing at this stage."

Berner, one of the first economists to declare that a recession is at hand, still fears the economy's risks are far greater to the downside than the upside.

"The CPI data this morning reinforced my conviction that higher energy prices have been a drag on both consumers' and business' discretionary spending power and profits," he said. "That's a key contributing factor to my view the economy is in a recession, and will stay in recession."

If that theory sounds similar, it could be because it's very similar to the one expressed by Greenspan regarding the impact of higher energy prices during his Senate testimony on Feb. 13.

Berner and Crescenzi each noted Greenspan also said "downside risks predominate," in his appearance on Capitol Hill last week.

So if Greenspan still holds those views -- that higher energy prices are not inflationary and downside risks predominate -- then the Fed is likely to cut rates soon. The fed funds futures contract is currently pricing in near certainty of a 50 basis-point rate cut on March 20 and around a 70% chance of a rate cut prior to the meeting.

But if the Fed does ease aggressively again, particularly intermeeting, the question becomes whether investors will start to view the central bank as pushing on the proverbial string. The stock market seems to be indicating that's all the Fed was doing with the 100 basis points of cuts in January.