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Jubak's Journal
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Why the Fed needs to hike rates soon
The Federal Reserve has been so focused on fighting deflation that investors are beginning to fear it has missed signs of rising inflation. If the Fed doesnt act soon, the markets could see real trouble.
By Jim Jubak
Here is the conundrum that is bedeviling todays stock market: If the Federal Reserve hikes rates, its bad news for stocks. If the Fed doesnt hike rates, it could be worse news.
A growing minority of Wall Street investors thinks that the Fed could be on the verge of letting inflation spin out of control. And its exactly that possibility that gives credibility to fears about a repeat of 1994. That year, the Fed went on a rate-hike rampage, doubling interest rates through seven rate hikes that ended with a huge, three-quarters-of-a-percentage-point jump in November 1994.
Inaction by the Fed in June could add to investor jitters. In a stock market driven by worries and emotions, that would be a big negative.
Rate-hike fans see a dark scenario unfolding if the Fed doesnt move. Their fears can be summed up like this: The Fed has kept its attention focused for too long on deflation and the danger that falling prices would choke off business investment and stall the economy. The latest May 4 statement from the Feds Open Market Committee, the body that sets short-term interest-rate targets, still calls the dangers of deflation and inflation about even. The risks to the goal of price stability have moved into balance, is the way the FOMC put it.
That ignores, the inflation worrywarts insist, evidence that inflation has increased and that further increases are building. The Fed has only a limited time to act, they say, before expectations of future inflation get embedded in the economy and in consumer and business behavior. Once that happens, history shows, it takes more than a few 25-basis-point interest rate hikes to stamp out that inflationary psychology. Which is why, these investors say, the financial markets should worry about a replay of 1994 if the Fed doesnt act now. (A basis point is one one-hundredth of a percentage point.)
This argument, of course, depends on the strength of the evidence that inflation is picking up.
Inflation so far isnt alarming, but . . .
On the surface, the numbers dont seem to support a belief that inflation is about to come roaring back.
Inflation in April, according to the Consumer Price Index (CPI) reported on May 14, looked mild indeed. With a 0.2% rise in the CPI, inflation is now running at 2.3% year over year. That certainly isnt alarming.
Go deeper into the numbers, however, and theres just enough in the trends to make the inflation is stronger than the Fed thinks argument seem plausible. That 2.3% year-to-year rate is up from 1.7% last month. That fuels the argument that the rate of increase is rising.
And the core CPI, which measures inflation after subtracting the effects of volatile energy and food prices, rose 0.3% in the month. Its now running at a 1.8% year-on-year rate. Annualizing the core inflation for the last three months, however, shows it climbed at a 3.3% rate. So, it sure looks like weve seen the end of a downward trend in core inflation that took the rate down to a 40-year low of 1.1% for the period from November 2003 to January 2004.
The April numbers arent isolated data points. The March readings, which also showed only mild inflation at first glance, revealed the same deeper inflationary tendency. The CPI was up just 1.6% year over year -- but up 5.1% if you annualized the trend for the first three months of the year.
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The volatile food and energy components were just that -- volatile. Food prices were up 3.2% year-to-year in March, and energy prices were up 38% if you annualize the three-month trend. I certainly dont expect energy costs to rise at that short-term pace over a full year, but energy prices did climb 6.9% in 2003.
Economists like to take energy and food prices out of the CPI because they can jump around so much month to month. That practice, though, seems to ignore the way that todays food and (especially) energy prices work their way through the economy to become tomorrows prices for airline tickets, electricity, steel and plastics. Last week, Wal-Mart Stores (WMT, news, msgs) told Wall Street analysts that increases in gas prices were taking better than $7 a week out of the disposable income of a typical Wal-Mart customer. Thats real inflation in my book.
In fact, working backward in the economy from the prices that consumers pay to those charged at the wholesale level and at the producers level shows that inflation in general may be working its way down the pipeline.
Pressures building up in the production pipeline
Lets look at the April Producer Price Index (PPI) report, which came out on May 13.
The index climbed by an unexpectedly large 0.7%, way above the 0.4% consensus estimate of economists. That puts the year-on-year rate of increase at 3.7%. (The core rate, minus energy and food, was 1.6%) Theres always inflationary potential when the PPI (at 3.7%) is climbing faster than the CPI (at 1.6%). The discrepancy often signals that price pressures are building up in the economic pipeline but arent yet being felt at the consumer level.
And you can certainly see evidence of inflationary pressures in the pipeline by looking at the price increases that the PPI measures at different points in the production process. Compare the 1.6% increase the core index for finished goods with the core price increases for goods at the intermediate, or wholesale, level at 4.2% year-over-year. And the core price increases at the intermediate level are lagging even further behind the 26% year-over-year increase in core prices at the crude, or raw materials, level.
Companies are eating price increases
This huge discrepancy in inflation at the consumer, wholesale and raw-materials levels has persisted for months now. Companies that sell to consumers have been eating price increases rather than pass them onto customers out of a fear they will lose market share. And inflation at the raw-materials level has been offset by cost cutting and gains in manufacturing efficiencies.
Three developments suggest that this period of stable consumer prices may be ending.- Consumer companies have announced price increases and then stuck to them. Procter & Gamble (PG, news, msgs) and Kimberly-Clark (KMB, news, msgs) announced increases in the prices of their paper goods in March. Those price increases are still scheduled to go into effect this summer. Were not talking about tiny 1% price increases, either. Heres what Kimberly-Clark announced: Prices for bathroom tissue, paper towels and napkins will be increased effective July 11, 2004, and facial tissue prices will rise effective Aug. 29, 2004. The increases are expected to average approximately 6%.
- China is reporting an uptick in its own inflation. This may seem strange since China has produced much of the deflation in the prices of manufactured goods. Exactly how much of an inflation uptick China is experiencing is open to speculation. The official Chinese position is that inflation is now running at 3% a year. That would be more believable if 3% werent also the official inflation ceiling established by the Chinese government. Morgan Stanley estimates that the true inflation rate could be as high as 8%. China, which had been exporting deflation to the United States, now looks like it will be exporting inflation.
- Wal-Mart predicted minor inflation in the prices of general merchandise by the fourth quarter. Pay attention to what Wal-Mart says. It accounts for 8% of all U.S. retail sales (after youve excluded car sales). Id say it has more influence on U.S. inflation right now than Alan Greenspan and the Fed.
Wall Street, after listening to the companys most recent update, is predicting better margin control, which is Street-speak, I think, for Wal-Mart keeping more of its savings by wringing lower prices out of suppliers for itself and passing less of them on to consumers. In the first quarter, Wal-Marts gross margins climbed 25 basis points thanks to savings from global outsourcing (read "buying more stuff from China") and improved sales of higher-margin clothing. But that wasnt enough to offset increases in health-care costs, payroll and utilities. (See, energy does count everywhere in the economy.)
Wal-Mart may still be set on being the cost-cutting leader in retailing, but it looks like the pace of those cost cuts is about to slow. And that would give more wiggle room for price increases to all those companies that do big business with Wal-Mart.
A 1994 replay is not likely
None of this adds up to a guarantee of inflation or solid evidence that the Fed has let inflation get so established that Alan Greenspan and company will have to increase interest rates faster than most investors now expect.
Even if inflation is established and the Fed has to play catch-up, that doesnt mean were in for a replay of the 1994 scenario. I dont believe such a replay is likely. In 1994, the Feds move to raise rates caught the stock and bond markets by surprise, and no one can argue that this time the Fed hasnt telegraphed its intentions repeatedly. And the deflationary trend of the prices of global manufactured goods, even if China is starting to experience its own inflation, is an important damper on inflation at the consumer level that didnt exist in 1994. Its hard for me to see, given the current global economy, how U.S. inflation could zoom ahead so strongly in the short term to necessitate a quick 3 percentage point increase in short-interest rates like the Fed engineered in 1994.
This argument doesnt have to be right, however, to have a negative effect on the stock and bond markets. It merely has to be emotionally convincing enough to shift a significant number of investors from buyers or holders to sellers. The impact of events like the continued war in Iraq, surging oil prices, and uncertainty about the direction of Chinese economic policy have made this an emotionally fragile market. Its vulnerable to overreaction on inflation evidence of that sort Ive just presented. Every bit of evidence that argues for a return of inflation that accumulates without a response by the Fed just adds fuel to fears that the Fed lacks the will to fight inflation.
The financial markets might not like an interest-rate hike at the end of June, but since that increase is pretty much already priced into stocks and bonds, a swig of bad-tasting preventive medicine might be the best thing the doctor can deliver.
Otherwise, an already nervous patient is likely to toss and fret, imagining that the sickness is getting worse and that the ultimate treatment will have to be unpleasant indeed when it is finally administered.
New developments on past columns
My hell-in-a-handbasket portfolio
Political turmoil in India has taken a huge bite out of all Indian stocks, and shares of ICICI Bank (IBN, news, msgs) have been no exception. They were down more than 26% on the year as of Friday and lost nearly 10.3% of their value on Friday alone.
In the final round of Indias national elections, voters turned out the government of prime minister Atal Bihari Vajpayee in favor of the venerable Congress Party, now headed by Italian-born Sonia Gandhi. Indian stocks have been falling during much of the campaign as investors feared that the government, which has pushed through an ambitious program of sales of state-owned companies and economic reforms, would fail to win a majority in the election. The size of the Congress Party victory, with the party capturing 149 seats, is likely to end the market decline, in my opinion, since what Indian investors feared most was government by a weak and unstable coalition. A Congress Party government wont be as favorable to business as the outgoing regime, certainly, but its leaders have already indicated that they will shift the emphasis of future economic reforms toward the countryside from the cities rather than attempting to undo the last governments program.
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned shares in the following equities mentioned in this column: ICICI Bank. He does not own short positions in any stock mentioned in this column.
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