Sound, Fury but No Inflation

The economy is expanding rapidly but with no impact on prices.
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Though powerful economic forces rage around it, inflation remains calm.

The latest evidence is the government's consumer price index, released Tuesday. It showed prices retreating 0.2% in November, or 0.1% factoring out food and energy. While it is the first contraction since April, it is consistent with a series of reports showing inflation to be close to nonexistent.

An unprecedented combination of monetary and fiscal stimuli coupled to send economic growth on an 8.2% tear in the third quarter of 2003. And the economy has remained strong since then. Industrial production figures Tuesday showed a 0.9% increase in November, the largest increase since October 1999.

Yet despite the best growth rate in 20 years, the

Federal Reserve

remains a formidable offset, holding interest rates steady at a 45-year low of 1%. With strong growth and real interest rates practically in negative territory, inflation will continue to get a lot of attention in the coming year.

"Peering into next year, the inflationary character of the economy will likely prove the most important issue facing economists, policy officials and investors," said James Paulsen, chief investment officer at Wells Capital Management.

Inflationary pressures are already mounting: commodity prices have surged this year; the dollar is hovering near an all-time low vs. the euro; tuition costs are skyrocketing and skyrocketing health care costs show no signs of slowing. Powerful forces line up on the other side, however, including higher productivity and the weak labor market.

So should investors begin positioning portfolios for a nasty dose of inflation and a vicious rollback of

Fed

rate cuts? Most economists say no. The overwhelming consensus is that inflation will be mild in 2004. What's arguably more alarming is the unanimity of the consensus. Even its proponents wonder if such complacency could lead to grief.

Looking for Inflation

"Seldom do we remember a time when there was more policy juice being brought to a recovery," noted Paulsen. "The Fed has been in an easing mode for almost three continuous years -- government deficit spending in the last year is in excess of $350 billion

or more than 3% of GDP -- and the U.S. trade-weighted dollar has declined by about 25% from its 2002 highs. This list has to be the economic policy for creating inflation."

Richard Berner, chief U.S. economist at Morgan Stanley, thinks this combination of fiscal and monetary policy will succeed. "The three key ingredients for the rebirth of pricing power -- 'capital exit,' a deflation-fighting Fed that is implicitly blessing a weaker dollar and stronger growth -- are all in place or getting there," he said.

But there are already signs of rising prices. Commodity prices have surged this year, with the CRB index up 11%. Crude oil prices have risen almost 30% since January and hover near $30 a barrel. Most agree that businesses will be unable to pass along higher commodity costs to the consumer just yet.

Productivity gains have offset some of the rise in commodity prices. And unit labor costs dipped 5.8% in the third quarter. Excess capacity remains too high and the labor market too sluggish for corporations to wield pricing power.

Services, not goods, have shown the most price acceleration, with sharp increases in health care, tuition and housing, three of the American consumer's biggest expenses. All three have outpaced the consumer price index, increasing by 2.4%, 7.3% and 3.7%, respectively, in the past year. But historically low mortgage rates have allowed consumers to extract cash from their homes to offset some price increases.

Neither Paulsen nor Berner expect a surge in inflation in 2004. Berner, for example, forecasts CPI at 1.6% in 2004 and 2.2% in 2005. A vast majority of economists see inflation at between 2.5% to 3.0%, but not the 4% to 5% hit in the late 1980s and 1990 that could seriously derail economic growth or prompt the Fed to start jacking rates.

"Productivity, global competition and excess capacity will keep inflation under control," said Kenneth Kim, U.S. economist with Stone & McCarthy Research Associates. He sees inflation at around 2.5% in 2004, close enough to what he feels is the Fed's implicit inflation target of 2.0%.

Ram Bhagavatula, chief economist for the Royal Bank of Scotland, thinks prices will be restrained by the output gap, the difference between current output and trend growth, or what the economy could produce at full capacity. When growth moves above this level, inflation generally follows. Bhagavatula thinks productivity gains may now allow trend growth of 3.0% to 4.0%.

The labor market also remains weak. The unemployment rate is stubbornly high at 5.9% and job growth sub-par at this stage of a recovery.

The Case for Further Disinflation

A vocal minority of economists still say it will be some time before pricing power returns and at least one thinks the risks remain tilted toward disinflation.

"Inflation will not pick up until the output gap closes," said Drew Matus, financial market economist at Lehman Brothers. Plus, the current labor picture "makes it difficult for employees to ask for a raise. These are disinflationary pressures."

William Dudley, chief economist for Goldman Sachs, added: "Fed officials want inflation to rise. Until this occurs or seems imminent due to increased resource utilization, they are likely to keep the Federal funds rate target unchanged at 1%," he said in a note to clients. Dudley maintains the Fed will not tighten until 2005.

Fed Timing

In the end, it will most likely come down to the Fed's timing and whether it can keep the recovery from overheating. In its December policy statement, the Fed said the probability of an unwelcome fall in inflation now appears almost equal to that of a rise in inflation. Previously, the Fed saw disinflation as a greater risk. On the other hand, the minutes of its FOMC meeting suggested rates could remain low longer than many had previously thought.

Yamarone has confidence in the Fed and considers its recent track record excellent. During Chairman Alan Greenspan's tenure, "the Fed has had to navigate the economy, with only one instrument of monetary policy, through two recessions, two wars in Iraq, terrorist attacks on the U.S., corporate malfeasance, and the internet bubble, and yet the consumer has not stopped spending in 47 consecutive quarters."

Even if inflation rises above 3%, Yamarone thinks the Fed will not "combat it until after the November presidential election and until the unemployment picture improves." Such patience could limit any damage to financial markets.

Fear Could Tilt Risks

Despite all of the arguments against inflation, Paulsen remains concerned, even though he shares the consensus view.

"Even a modest rise in inflation could increase inflationary fears more than proportionately and lead to a significant tightening by the Fed and a spike in Treasury bond yields," he wrote in a research note.

Paulsen points to the mid-1990s. Actual inflation rose to 3% in September 1994, peaking at 3.2% in May 1995. Still, inflation fears prompted the Fed to tighten dramatically. The federal funds rate went from 3% in February 1994 to a peak of 6% a year later. As a result, 10-year Treasury yields spiked from about 5.6% in February 1994 to more than 8% in November 1994. The

S&P 500

plunged nearly 9% in the first few months of the tightening cycle.

Financial markets are often driven more by perception than by reality. Inflation may look well under control, but economists say the consensus is too deeply rooted and Treasury yields too low to weather any surprises -- real or imagined.