Get Ready for More Rate Hikes

Inflation pressures are written all over today's data, despite their apparent benign flavor.
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As usual, key economic reports released Friday reveal as much as they conceal. There's a picture of strength on the one hand -- strong second-quarter GDP growth, strong Chicago PMI and improving consumer sentiment. On the other hand, there's tame inflation with the employment cost index of the GDP report.

But inflation pressures are written all over the data and that spells no end to the

Federal Reserve's

rate-hike campaign.

That's why the Treasury market took a hit after news that the economy grew at a 3.4% pace during the second quarter, just shy of consensus expectations for 3.5%. Bonds also fell further upon news that consumer sentiment, as measured by the University of Michigan index, improved in July, as did manufacturing activity in the Chicago region.

The benchmark 10-year bond was recently down 16/32 while its yield rose to 4.26%.

Stock indices also headed lower. The

Dow Jones Industrial Average

(DJI)

was recently down 0.4% to 10,663.92, and the

S&P 500

(SPX)

was off 0.5% to 1237.35. The

Nasdaq Composite

(NASDAQ)

was down 0.6% at 2185.99.

GDP growth was expected to slow down some from 3.8% in the first quarter, due to the infamous energy-induced soft patch experienced during the spring. Due to a lack of buying appetite, businesses accumulated $58.2 billion in unsold inventories during that period. And $6.4 billion of that was liquidated during the second quarter at the expense of new production, which shaved 2.3% off GDP growth.

That liquidation also means that inventories accumulated at a slower pace in the quarter. And together with a faster pace of sales growth of 5.8%, that points to better tomorrows. "When inventories grow very slowly and final domestic demand grows very quickly, firms typically respond by boosting output sharply in subsequent quarters," says Goldman Sachs economist Jan Hatzius.

Hatzius believes that his forecast for average growth of 3.1% over the next four quarters may now be too low.

There's more. The GDP's personal consumption expenditure index, a measure of inflation, is now up 2.0% on year-to-year basis, compared with 1.6% in the first quarter. And productivity, at 1% for the second quarter, is waning.

"The GDP figures could hardly have been worse from the perspective of the interest rate doves," says Bill Dudley, Goldman's chief economist.

On the comforting side of the inflation story, the employment cost index rose 0.7% in the second quarter, below expectations for a 0.8% gain. A gain of 0.8% in benefits was the slowest since the first quarter of 2002. And wages and salaries rose only a modest 0.6% during the quarter.

But employment costs, although they're high on the Fed's watch list for inflation, are only part of the current equation.

Inflationary pressures -- mostly energy and housing-related -- are there and growing, even if they're not officially part of the discussion. In fact, energy and real estate gains are not even taken into account in the GDP's core PCE (personal consumption expenditures) deflator, which actually settled in the second quarter. Core PCE is one of Fed Chairman Alan Greenspan's key gauges of inflation and is usually what investors monitor to get insight into the Fed's thinking.

But that gauge is becoming increasingly faulty, says Joel Naroff, president of Naroff economics.

On the one hand, the core PCE deflator was brought down by the huge sales incentives from the auto industry (which also contributed to the inventory drawdown) in the second quarter. But "the oil price surge, which raised consumer costs, doesn't count," Naroff says. "Now that's fuzzy logic if I ever saw it."

The economist says he's had discussions with Fed officials who'll admit that the Fed's switch from the consumer price index, then to the core CPI, then to the core PCE deflator, is putting the central bank less and less in touch with "the real world." (Echoing that official Washingtonian view were comments by Treasury Secretary John Snow, who said on

CNBC

that "energy isn't as important a component of the economy as in the past.")

Presumably, Greenspan's repeated comments about housing "froth," dangerous lending prices and energy are evidence that he and the Fed now fully incorporate these factors in their thinking on inflation.

Yet, "we haven't seen this kind of price increases sticking for this long for a very long time and the Fed knows it," says Naroff.

Bottom line, interest rates will continue rising well into next year.

In keeping with TSC's editorial policy, Godt 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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