|BUSINESSWEEK ONLINE : MAY 31, 1999 ISSUE|
U.S.: Is Inflation Coming Back?
No, but a jump in prices startles the markets and the Fed
In Wall Street's galaxy, the Phantom Menace is inflation. It's the Dark Side of the economy's Force. The financial markets know that benign inflation is the single most important factor supporting the economy's amazing performance of recent years. Without it, this economic Eden will collapse.
That's why the May 14 news of an unexpected 0.7% jump in the April consumer price index, the largest monthly rise in more than nine years, looked as scary as Darth Maul wielding his light saber. The surge touched off a selling frenzy. The Dow Jones industrial average plunged 194 points for the day, and the yield on the 30-year Treasury bond spiked to a 12-month high of 5.92% as fears of an interest-rate hike by the Federal Reserve began to creep back into the market's psyche.
The Fed partly validated those fears at its May 18 policy meeting. Although it stopped short of raising interest rates, the policymakers announced that they were now leaning toward tightening, the kind of formal decision that heretofore was not made public until weeks after policy meetings. The Fed said it was ''concerned about the potential for a buildup of inflationary imbalances,'' and it cited ''already tight domestic labor markets and ongoing strength in demand in excess of productivity gains'' as the reasons for its heightened state of alert.
The stock and bond markets bristled at the Fed's move, but because of the April CPI surprise and recent strong economic data, the Fed's shift in thinking had already been anticipated by the markets and largely priced into stocks and bonds, starting with the May 14 sell-off. The Fed's new openness means that the central bank can tighten financial conditions in the economy simply by disclosing its policy leaning without actually raising short-term rates.
THE CRUCIAL QUESTION for the outlook is this: Was the CPI jump real or just special effects? The April data certainly looked ominous. The markets had expected a sharp CPI advance because of the 67% spike in oil prices from mid-February to early May. But they were shocked by a 0.4% surge in the core index, which excludes energy and food, the biggest increase in more than four years.
In addition, a broad-based gain in industrial production added to fears that not only is the economy not slowing down, but that one of the economy's softest areas was gaining fresh momentum. Weak factory employment and output have been huge factors holding down wages and goods prices.
However, data other than the April CPI argue that there is no reason to turn into an inflation-phobe just yet. Most important, wage growth is slowing, indicating that there is still some slack in the labor markets. In addition, a great chunk of U.S. industrial capacity remains idle, and businesses will not have any pricing power until supply channels tighten up.
Finally, despite some stabilization outside the U.S., a glut of global capacity persists. Any global upturn is going to be too gradual to absorb that excess capacity very quickly. That means the dollar should remain strong, and falling import prices will continue to offset increases in domestic prices. Note that import prices stopped falling from October through February as a result of last year's drop in the dollar. But import prices resumed their decline in March and April, in the wake of the dollar's renewed strength.
IN ADDITION, A CLOSE LOOK at the April data shows why last month's CPI surge is less than meets the eye. A 6.1% rise in consumer energy prices, a record one-month rise, accounted for 0.3 percentage points of the 0.7-point increase in the overall index. Energy has accounted for most of the ups and downs in inflation during the past two years. Moreover, oil prices have actually fallen in recent weeks, likely reflecting still-weak global demand and ''cheating'' by some of the oil-producing nations that had agreed back in February to cut output to specified quotas (charts).
Only two categories accounted for about half of the 0.4% increase in the core index: Apparel prices rose 1.5%, after declining for six months in a row, and tobacco prices jumped 3.6%. Tobacco inflation is running at 33% per year, but that has nothing to do with the economy's inflation potential. And apparel prices have been below their year-ago level for five months in a row. Excluding tobacco and apparel, the core index rose close to the 0.2% that the markets had been expecting. Moreover, the April producer price index looked as tame as ever.
KEEP IN MIND, HOWEVER, that the price indexes are history as far as the Fed and the Street are concerned. A bigger concern is what's next for inflation. For that, policymakers and investors look at how the economy is doing. What they want to avoid is an overheated economy that will begin to push up costs and prices. That's why the unexpected 0.6% advance in industrial production was another reason for the May 14 sell-off.
Unlike the CPI jump, the output numbers appear to be signaling a reversal from past trends. March output was revised to show a 0.5% rise, instead of the tiny 0.1% gain first reported. In April, a wide range of industries from household appliances, clothing, and energy to computer equipment posted substantial increases.
As it stands, though, U.S. industry has tons of idle capacity, so cost pressures are a long way off. Because of big investments in high-tech equipment, capacity over the past year has grown more than twice as fast as output has. The operating rate for all industry did edge up in both March and April, to 80.6% from February's 80.2%. But that rate is well below the 85% mark where bottlenecks lead to price hikes (chart).
Manufacturing's nascent recovery comes just as retailing and housing are taking a breather. But their slowdown is a tap on the brakes, not a full stop. Retail sales rose just 0.1% in April, and the March sales gain was cut in half, to 0.1%. Much of the weakness, though, was at car dealerships. Excluding vehicle purchases, store buying rose a stronger 0.4% in both months. At the same time, housing starts fell a sharp 10.1% to an annual rate of 1.57 million in April. Starts hit their lowest level in a year, and every region except the West showed a decline.
But don't expect retailing and housing to weaken much further. Consumer fundamentals remain solid. Stock market gains are still adding to household wealth. And mortgage rates, though higher than they were last autumn, are very attractive.
What Wall Street fears, of course, is that superhot growth will ultimately become too much of a good thing. Investors and policymakers alike know that once inflation strikes, battling it can be very costly to the economy.
BY JAMES C. COOPER & KATHLEEN MADIGAN
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U.S.: Is Inflation Coming Back?
CHART: How Oil Has Skewed Inflation
CHART: Crude Prices May Have Topped Out
CHART: A Lot of Capacity Remains Idle
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