Debunking Deflation

Despite the Fed's new attentiveness, prices are rising in many places.
By Marc Dupee ,

I probably shouldn't second-guess Fed Chief Greenspan, but I have a different view about deflation: It isn't happening and it isn't on the horizon.

Sure, Greenspan told Congress yesterday that deflation "is sufficiently large that it does require very close scrutiny and maybe action on the part of the central bank." And, yes, April's headline

Consumer Price Index

number showed a 0.3% decline. But let's drill into the recent inflation figures and consider inflationary forces at work around the country.

Here's how the CPI breaks down: housing accounts for 40.04% of the index; transportation gets a 17.77% weighting; food and beverage consumes another 15.45%. and medical care reflects 5.56% of any price change in the index. These four groups alone account for the bulk -- 78.82% -- of the CPI.

Now let's look at prices in the two states that set trends for the country, California and New York.

Rents Still Inflated

Just this week, the California Association of Realtors reported that the median price of an existing, single-family detached home hit a new record during the first quarter of 2003, jumping 14.3% to $337,780. And in the Greater Los Angeles region, where more than half the California population resides, rents are expected to increase 8% to 15% between now and the end of September 2004, according to the University of Southern California's Lusk Center for Real Estate.

New York is no bargain, either. Rents for small, Upper West Side apartments in Manhattan are still going for $3,000 a month. I should know -- that's what I recently paid before moving back to California late last year. Lower-income tenants have higher rents to look forward to now as well. New York's Rent Guideline Board just gave preliminary approval to jack up 1-year rent-stabilized leases by 5.5% beginning in September. The justification? Higher operating expenses from their own escalating Price Index of Operating Costs.

In transportation, the internal components of the index comprise gasoline, airline fares and car prices. Even after most of the war premium comes out of energy prices,

July crude oil

still trades at the $29-a-barrel handle. Gasoline prices also are uncomfortably high as we kick off the summer driving season this Memorial Day weekend. Yesterday I filled up my gas guzzler here in L.A. for $1.79 a gallon, not exactly a deflationary deal.

And if the Metropolitan Transportation Authority of New York gets its way, subway fares, bridge and tunnel tolls and Long Island Rail Road fees will increase anywhere between 25% and 33%. MTA subways, buses, and railroads move 2.3 billion New Yorkers a year, or one in every three mass transit users in the United States. There's no way these price hikes are deflationary either. Airline fares also add to transportation costs. Surprisingly, they rose 0.9% in April.

On the other side of transportation costs, automobile prices continue to drop. Car companies offering 0% financing for five years is definitely deflationary. But the auto industry has an overproduction problem. Indeed, worldwide auto output has risen 20% over the past 10 years and production has stayed above 40 million vehicles annually since 1999. Resources in this industry need to be allocated more efficiently.

The price of basic foodstuffs is on the rise, too. Soybeans, cattle, hogs and pork bellies are trading just off contract highs. Sugar is a penny off contract highs and wheat and corn have broken their downtrends. Good weather and an abundance of tropical fruit seemed to have provided for a seasonal decline in April's prices.

Among the major components, medical care was the biggest gainer in April's CPI, rising at a 4% annualized pace. All told, housing, transportation, food and medical expenses look like they're on the rise in the trendsetting states. They have a very long way to drop before deflation sets in.

The

Producer Price Index

also isn't showing inflation. The most recent (May 15) headline figure looks deflationary -- initially. The PPI fell 1.9% in April. But strip out volatile energy and auto prices, and producer prices have fluctuated along with spending and industrial production levels for the past year, movement that is not representative of deflation. Also, core prices for intermediate goods, a separate component of PPI and a leading indicator for consumer inflation, were zero in April, and thereby maintained a 3.85% annualized rate of inflation.

The falling dollar, along with Americans' taste for foreign goods, also is inflationary. The U.S. economy still hasn't felt the full impact of the past year's 25% decline in the price of the dollar against the euro nor the 11% decline in value against the yen. The price of imports is still going up, another inflationary factor.

Markets' Reaction

Rationally,

December gold

is reflecting inflationary expectations. At $375 an ounce, it is one of the strongest momentum markets among the most widely followed futures contracts. Look to enter on pullbacks from the three-month high.

Debt futures are not reflecting inflationary expectations. Their rally into record territory is going the other way, reflecting deflationary expectations. The perception that the Fed will become a buyer of the long end of the yield curve (of three-, five- and 10-year notes) to combat deflation or economic stimulus provides major upside pressure. So, too, does the Japanese "arbitrage trade" I

wrote about on May 20. Indeed, the

Bank of Japan

recently said it offered 600 billion yen to buy Treasury bills on May 27.

Still, debt futures will need a steady stream of good news to keep their rally on the northbound track. Be on the lookout for traders front-running upcoming CPI and PPI reports. A whiff of inflation could send debt futures prices tumbling.

Marc Dupee is an independent trader and co-author of the book

The Best: Conversations With Top Traders. Dupee was formerly markets analyst and futures editor for TradingMarkets Financial Group. At time of publication, he held no positions related to this article, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While he cannot provide investment advice or recommendations, he invites you to send your feedback to

Marc Dupee.

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