RateWatch #412 – Inflated Perception

June 12, 2004 by Dick Lepre

What's Happening

The current account deficit - the amount of assets denominated in dollars and held outside the United States - was $144.9 billion for the 1st Q. That represents a 2-way street. The net trade deficit was $144.9 billion and the capital account surplus (excess of foreign investments in the U.S.) was equal to $144.9 billion. All things considered, this shows confidence in the dollar and the U.S. economy. Treasury yields are flat in morning trading. With most significant data for the month having been released and a broad consensus building that the FOMC will hike 25 basis points on June 30, the remainder of the month may be quiet.

CPI- Core and Overall

On Tuesday CPI data came out. CPI was +0.6% overall and +0.2% core (without food and energy).  While I was driving to work the guy who does the financial news on the San
Francisco all-news radio station was lamenting the fact that inflation was so high. He noted that the Dow was up and that the 10-year Treasury was up almost a full point. My "does not compute" alarm went off. 

When I got to my office I wrote the daily commentary that RPM uses for marketing and then looked at the New York Times web site.  This is how their story opened: "Prices paid by
consumers in May rose at their fastest rate in more than three years, the Labor Department reported today. But the news was greeted positively by stock and bond traders, who had been worried in advance of the report that the news might be worse than it was."

I know that the New York Times has taken some lumps in the past few years but this is down-right foolish.  (That or I must be watching too much Bill O'Reilly.) Treasuries rallied because  bond traders understand that the most significant piece of data is core CPI. If one looks at "overall" CPI there is too much month-to-month variation in food and energy prices. With the price of oil falling and the pump price of gasoline falling next month CPI overall may be negative or zero.  That does not  mean that we are having deflation. It means that the only thing that should be looked at is core CPI.

We should be concerned about inflation if and when core CPI is +0.4% and overall CPI is flat.  As an exercise, keep this in mind and let's see what the NYT says if this happens in the next few months.

The large size of the movement on Tuesday was due to short-covering by folks who made their bets on the wrong side. 

Of course, people are really affected by overall CPI. Everyone buys food and energy so indeed we are on a month-to-month basis, affected by the prices of those items. But anyone with any savvy about the economy knows that energy and food prices fluctuate and if we are looking, for example, at the intentions of the Fed those intentions will be divined only by looking at core CPI.

Inflation is higher than it was in 2003 but, considering the insanely low Fed Funds rate, inflation is quite tame.  The Fed will start hiking the Fed funds target to something approximating 3%. The Fed funds rate must be increased so that it is above CPI.  If CPI were to stay at, say, 2.5% the Fed funds rate could stay at 3% and permit GDP growth.  To the extent that CPI exceeds 3% the Fed Funds "floor" will have to rise.

In Congressional testimony Tuesday Greenspan said, "Our general view is that inflationary pressures are not likely to be a serious concern in the period ahead." He also pointed out that a continuing increase in worker productivity will allow for continuing increases in labor costs (wages) with no consequence.  If productivity flattens, then any increase in labor cost will have a  greater effect on inflation.

This is one of those economic issues that gets almost no coverage in the media.  A natural consequence of higher worker productivity is a cutback in hiring.  It appears the present jobs market in the U.S. has gotten past the point that GDP can grow solely on the back of increased
productivity.  We may well be at the beginning of a healthy jobs boom.  The fact that jobs came so late in this recovery may be a consequence of increased worker productivity but, if productivity growth can be maintained, then healthy GDP growth will be the order of the day.

Increased interest rates will help the dollar.  This will have the effect of making U.S. goods more expensive and help make the trade deficit larger.  This will take some of the top off GDP growth.  More stuff that is bought here (retail sales) will be imported.

The Fed is moving into what will likely be a difficult balancing act.  The four tasks of the Fed are: maintaining GDP growth, containing inflation, keeping interest rates low and maintaining the value of the dollar.  The emphasis is about to be shifted from GDP growth and very low rates to inflation containment and the dollar.

Interestingly enough, Greenspan has, of late, been addressing fiscal issues such as taxes and social security.  It will be interesting to see now that he is confirmed for what is presumed to be his last term as Fed Chairman, if he speaks out more openly on politically charged fiscal issues.

As for the Fed funds rate: look for the Fed to restore it to its "natural level" of about 3%.  Realistically, with the Fed Funds rate so low, that will take the better part of a year. The Fed must do this in an artful manner.

Getting out of the low rate environment to a "normal" rate environment involves risks that are not even identified at present.  The prolonged period of low rates has created a situation where there may well be "borrowed money bubbles." Hedge funds that are not properly positioned may be savaged. A slow and steady increase in the Fed funds rate mitigates the risks associated with borrowed money.

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