The Inflation Evil That Lurks
"A specter from the past has been haunting the stock market lately, and, as with most specters, the question is whether this one is mostly real or mostly imaginary.
The specter is inflation, and until recently, many investors thought it was dead and gone. Lately, if you believe the Federal Reserve, it isn't exactly ba-a-a-a-ck, but it is lurking. The Fed's fear of inflation, together with its clear intention to keep raising U.S. short-term interest rates to keep inflation in check, is the main thing that has prevented the much-awaited fourth-quarter stock rally from commencing . . .
A few weeks ago, I gave Professor James Hamilton grief over his 45 year chart of the 12 month change in CPI (1960 - 2005). The very long chart, IMHO, makes inflation look more modest versus its long history than say a 5 year chart would.
Indeed, the impact of any longer term charts is that they make major events look like ripples; You can barely see the 1987 crash on a long SPX chart, and even 9/11 is hard to spot on a 10 year Nasdaq chart.
Today's WSJ also uses a long term chart -- 35 years of CPI and Core CPI. It presents a case that the core underreports inflation. Note that even during the late 1970s peak of CPI, the Core rate tracked the overall index; In 1972-74, however, the Core lagged the CPI appreciably.
That lag is very analogous to the present BLS reporting, and in my opinion, why the Fed is fighting inflation so aggressively.
Note: I modified the WSJ chart, zooming in on the two periods:<spacer>
click for larger chart
Chart courtesy of WSJ
The entire article is worth reading; I have more excerpts, and the original chart, after the jump.
Specter of Inflation Haunts Dow
While Waiting for Fed's Fears To Subside, Investors Pull Back, Imperiling an Anticipated Rally
THE WALL STREET JOURNAL, October 24, 2005
Here's the original chart before my modifications version with zooms on the two periods:
Chart courtesy of WSJ
Why is this so important?
"Inflation is important to stocks because it influences just about every element that moves the stock market up and down.
The biggest impact is on interest rates, as rising inflation forces the Federal Reserve to push interest rates higher. Higher prices and higher interest rates boost costs for businesses and consumers alike, holding back sales and profit.
Inflation also hurts the financial underpinnings of stocks, making them less attractive, since a big piece of stock gains is eaten up by the rising cost of living. When inflation hits, investors tend to flee to alternatives such as real estate, gold, other commodities and money-market accounts."
I discuss all of these issues this past weekend in The Unpleasant Truth About Inflation. And yet despite the NYT, the WSJ and my own humble efforts, there is still a steady drumbeat begging the Fed to bail out their long only equity positions:
"So far, at least, few see any signs of inflation coming back the way it did in the 1970s, the last time the U.S. was dealing with sustained oil-price increases and a long-running foreign war. During that era, stocks languished. The fear is that the medicine the Fed will administer -- higher interest rates -- to prevent a return to those dark days, would also hurt stocks, though not as severely as in the 1970s."
I suspect those people who are bemoaning the Fed are "talking their book."
Also amusing: liumping in Greenie with the great Paul Volcker:
Many analysts believe that the main reason for the long bull market from 1982 to 2000 was the ability of Fed Chairmen Paul Volcker
and Alan Greenspanto bring inflation and interest rates under control. Consumer-price inflation went from more than 13% in 1980 to less than 2% in 2002. The yield of the 10-year Treasury note fell from more than 15% in 1981 to just above 3%, a 45-year low, in 2003. (strikeout added)
One problem for the market now is that those glory days are over. It is impossible for inflation and interest rates to fall that much again -- they aren't high enough. All investors can hope for is that inflation won't head up again -- and that is the problem today.
Fueled by oil prices, consumer-price inflation hit 4.7% in September, the highest level in 15 years. But excluding oil and food costs, the remaining "core" inflation rate barely budged. Wage increases have remained modest.
Signs of inflation bleeding into the rest of the economy have been few -- but enough to make the Fed worry. Real-estate prices remain high, and an influential Fed report released Thursday on business activity in the Philadelphia region showed signs that companies, faced with rising costs, are raising prices.
Because it can take nine to 12 months for an interest-rate increase to affect the economy, the Fed feels compelled to step in at the first whiff of a problem. That leads some investors to grumble that the Fed might be overreacting to a problem that doesn't yet seem very severe outside the energy world.
Many investors are hoping that, once the Fed shows signs that it is ready to stop raising rates, the stock market will rebound. But some worry that the Fed will raise rates too far, hurting profits, sending stocks into a bear market and creating a recession.
A very good column . . .
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Comparing CPI readings from the 60's to present day numbers is apples to Asian pears. More than 50% of the CPI is now hedonically adjusted. In 1965, there were no hedonic adjustments.
Looking at the details of a few products via BLS links, it's apparent that there are no adverse hedonic adjustments for (e.g.) electronic hardware items. Adding two VCR heads produces a deflationary adjustment, while eliminating the 800 number and perhaps charging $2 a minute for customer service by phone is ignored (thus not inflationary).
If LT interest rates rise appreciably, the housing market will slow, and the rate of increase of residential rents will increase. So two years hence, we may see a higher core CPI as measured, while actual inflation may be less at that time. The demand curve for rentals has shifted steadily over the past 15 years, due to the increase in home ownership.
Up until now, the (diminished, now 30%) portion of households that rents has driven the CPI down. Now that 30% may move higher, resulting in an overstatement of the CPI in coming years. This is a rather perverse argument for owning TIPS at current levels (implied CPI of ~2.6% over the next ten years).
Posted by: Greg | Oct 24, 2005 9:45:01 AM
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