Burning Down the House

Spiking crude props up the CPI, a trend that will one day threaten the real estate market.
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Oil, inflation and housing ... Oh my!

The three bogeymen that keep Wall Street awake at night joined forces in Tuesday's round of economic data. The result was some pretty inspired selling.

Recently, the

Dow Jones Industrial Average

was down 80 points to 10,555, while the

Nasdaq Composite

was losing 18 points to 2149.

The government said the consumer price index, its main inflation gauge, shot up 0.5% in July, the biggest increase in three months. The gain surpassed expectations on Wall Street, with economists forecasting 0.4% growth, but observers were quick to point out a tame reading on the core index.

Excluding food and energy prices, the CPI was up only 0.1%, which was below expectations. And that brings us to what most bulls and bears alike agree is the most troubling statistic in the economy: soaring oil prices.

Record-setting spikes in prices for crude futures last month were primarily responsible for the inflationary forces reflected in Tuesday's CPI report, and things have only gotten worse in the dog days of August. Last week, prices appeared to be hurdling toward a once-unthinkable $70 a barrel, topping out at $67.30.

Since then, oil has retreated a bit, but that provided little solace to investors Tuesday as prices hovered around $66.50, stocks dropped and the chief executive of the world's largest retailer proclaimed that energy costs posed a threat to the company's performance in 2005.

"I do feel good about the economy, but I do worry about the effect of higher oil prices," said

Wal-Mart's

(WMT) - Get Report

CEO, Lee Scott, on a prerecorded conference call. The call featured a muddled forecast for Wal-Mart's performance in the back half of 2005, disappointing investors and sending the stock down recently by more than 3%.

Of course, Wal-Mart is especially relevant here because it represents such a large slice of consumer spending -- the primary engine of U.S. economic growth. Furthermore, the discounter's low prices attract a disproportionate slice of low-income shoppers, a population that is particularly sensitive to prices at the gas pump.

On its conference call, Wal-Mart noted that half its debt is tied to so-called floating interest rates -- rates that rise and fall in concert with the 10-year Treasury note. Rates have been floating at historically low levels for years now after the

Federal Reserve

instituted an unprecedented period of monetary stimulation in order to ease the pain of recession.

Not coincidentally, many of the debt burdens shouldered by Wal-Mart's customers are tied to floating rates as well. Consumers indulged the Fed by taking advantage of low rates and going on a borrowing binge to fuel the spending that was largely responsible for keeping the economy afloat as Wall Street waited for the economic recovery to kick in. The binge manifested itself in a variety of ways, from credit card spending to student loans to auto financing. But the main windfall took place in the mortgage market, as people bought new homes with no money down and participated in a wave of refinancings to provide extra cash for spending.

This, in turn, drove the red-hot real estate market, which has posted unprecedented gains in recent years, leading to widespread warnings that the same bubble that existed for Internet stocks in the late 1990s has shifted into the housing market. Tuesday's housing data depicted a sector that is either very strong or overheated, depending on whom you ask.

The Commerce Department said construction starts on new homes and apartments fell a slight 0.1% in July. The decline left housing construction at a seasonally adjusted annual rate of 2.042 million units last month, down from a revised 2.045 million units in June. Building permits, however, went up for the month to an annualized rate of 2.167 million from last month's revised 2.132 million.

With all this unfolding, the Fed has been on a 14-month campaign of 10 consecutive quarter-point hikes in short-term rates in an attempt to rein in the money supply and keep inflation in check. Last time around, it showed no signs of letting up in the months ahead, sticking with its mantra of raising rates at a "measured pace."

Meanwhile, long-term interest rates have stubbornly refused to follow conventional wisdom and creep back up toward historical norms. On Tuesday, the 10-year Treasury bond was up 15/32 in price to yield 4.23%. At that level, its yield remains more than 200 basis points below where it stood a decade ago in 1995, when the economy stood poised at a similar perch on the economic cycle.

Fed Chairman Alan Greenspan called this phenomenon a "conundrum." If inflation data remains worrisome, the Fed likely will continue raising rates. If the conundrum should ever reverse itself, and long-term interest rates go higher, as one would expect, Wal-Mart and its customers could find themselves with even higher cost burdens.

The economy's salvation could lie in wage growth and employment gains, which appear to be on track, judging by improvements in the government's monthly jobs numbers. But Tuesday's report from the manufacturing sector left much to be desired.

The Fed reported that industrial production rose just 0.1% in July, the weakest showing in three months. The market had been expecting a 0.5% gain. Output increases at factories and utilities slowed after big gains in June while mining output actually fell.

One day's data do not an economy make, but Tuesday's action shows that Wall Street remains sensitive to potholes in the yellow brick road.

In keeping with TSC's editorial policy, Worden doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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