Tags: Analysis: | Inflation | Dollar | Really | Behind | Fed | Move

Analysis: Inflation, Dollar Really Behind Fed Move

Tuesday, 22 March 2005 12:00 AM

While some analysts expected a half-point increase, the Fed opted for a more conservative approach. Its quarter point increases have become standard fare.

On June 30, 2004 the Federal Reserve announced its first tightening in monetary policy since May 2000 by raising the Fed Funds rate to 1.25%. Since then the Federal Open Market Committee has raised rates a further five times.

With another rate increase behind us economists and Fed-watchers were more interested in another less predictable question. That question is whether the Fed would drop the expression 'measured-pace' from its statement.

The measured pace phrase remained in the Fed's prepared text accompanying the announcement.

But a subtle reference within the text sent chills down bond and stock traders spines.

The Fed said that, "pressures on inflation have picked up in recent months and pricing power is more evident. The rise in energy prices, however, has not notably fed through to core consumer prices."

That news was taken badly by stocks quickly reversing a near 40-point gain for the Dow industrial average. 10-year notes fell on the news sending yields back to 4.59% from 4.47 before the announcement.

The Fed along with other market-watchers will note over the course of the next few days as to whether the latest move is enough to increase the price of longer-dated bonds.

The Fed has recently admitted confusion at the sanguine reaction by bond markets to the nine-month old tightening process.

Earlier in the day stocks and bonds had reacted positively to news that producer price pressures increased strongly again at 0.4% for the month of February and at an annual pace of 2.8%.

Gasoline and food were the main culprits. Whether the increase in costs will be passed along to the consumer will determine future Fed policy.

The Fed's increase in rates may be more closely linked to the dollar - which has been on a downward spiral for months now.

The dollar weakened earlier in the day as traders began to fixate on the likelihood that the 'measured pace' language would remain this month.

Creeping Inflationary Pressures

The reasoning that economists and traders are so fixated stems from the fear of creeping inflation. The current consumer price index or CPI as it is referred to stands at 3.0%.

Having based in 2002 the basket of everyday items has slowly been increasing. As recently as November, the year-over-year pace of inflation was 3.5%.

The question is: can these numbers be believed? With oil prices skyrocketing - they appear to have little effect on overall inflation. Does that make sense?

With this period of easy money behind us the Fed has slowly taken away the proverbial punchbowl and some economists predict that the consumer will be left nursing an almighty hangover in the coming months.

The tipping point may come when long-term rates become impacted. That, in turn, will affect mortgage rates. As these rates increase, new home building and home sales will slow. More worrisome is increased rates on holders of ARMs - adjustable mortgages.

With CPI at a relatively acceptable level to policy-makers, economists note that a wave of inflation has the potential to develop into tsunami proportions. The reason being that there is a flipside to some of the medicine that the economy is imbibing.

That medicine is a weakening currency, which the authorities have hitherto turned a blind-eye to.

On the one hand the cheaper greenback is a boost to exporters who become increasingly competitive abroad, but on the other it has paved the way to the rise in demand for an alternative asset class, which threatens to unleash substantial inflationary impacts. A weaker dollar is associated with rising commodity prices since they are a store of wealth as the dollar is eroded.

Pressure From Manufacturers Passed on to Consumers

Take a look at the producer price index if you really want to know what's happening to the power of the dollar in your pocket. The PPI as it's known, is the inflation index of manufacturers and industrialists. It is this index that has the potential to feed into the CPI of the future.

Today's data showed producer prices rose at the monthly rate of 0.4% to give a year-on-year gain of 2.8%. That was the largest gain in seven years, and came on top of a 2.7% gain in January and against a decline in the monthly rate in December's rate.

This price index measures a variety of categories of producer inputs ranging from finished goods to intermediate goods to crude materials. The most recent trough in the price of finished goods was in May 2003. Since then the index, which measures them has risen by 7.2%. Currently the price of finished goods leaving the factory gate is 4.7% higher than one year ago.

Big Business in a Position to Make Prices Stick

XM Satellite Radio Holdings, the largest U.S. pay-radio company recently increased its monthly subscription rate by some 30% to $12.95 per month proving that companies are in a position to make price rises stick.

Alcoa on the other hand is in the middle of a three-year $1.2 billion cost reduction program. They announced further measures today to cut operating costs including further asset sales and 2,000 job cuts over the next year. Despite producing aluminum and selling it at the highest price in 10-years, the company faces surging electricity and other raw materials costs, which account for one-third of the overall production cost.

But to get a real feel for the inflationary potential of this environment take a look at what some more core manufacturing based companies are doing. A Fed survey pointed to evidence that it was becoming easier to make increasing raw materials costs stick. Leading acrylic producer Rohm & Haas recently announced a 20% increase in paints used in North American automotive coatings citing rising costs. Caterpillar is set to move more than just the earth when it raises the price of its earth and mining equipment for the second time this year. Deere & Co, the world's largest farm-equipment maker, while announcing still-healthy profits, said that it too was boosting prices of new farm equipment as farmers replaced aging machinery simply because the company itself faced higher material input costs.

Inflation Under Reported

Several people argue that the Bureau of Labor Statistics who track and compile prices consistently manage to understate the general level of prices. It's not in the government's interest to have runaway prices as it would exacerbate the cost of servicing the debt burden as well as undermine the value of the dollar.

Assistant commissioner at the BLS, David Johnson recently told USA Today that while the BLS attempts to reflect the experience of the average consumer, 1500 callers each month let him know that they simply don't fit the bill when it comes to being Joe Average. With tepid increases in Social Security payments and seemingly giant leaps in Medicare premiums, the more vulnerable elements of society affirm that the CPI basket simply doesn't tell the truth.

Bond fund managers Bill Gross of PIMCO and George Strickland at Ladenburg Funds make separate arguments as to why they believe that the CPI understates inflation by about 1%.

Gross says the BLS makes so-called "quality-improvement" adjustments. Anyone who has recently replaced their old chunky computer monitor for a flatter LCD panel will know what we mean here. The BLS makes adjustments to reflect better technology or a bigger bang for your buck. Despite falling prices for new computer hardware you still have to physically spend the cash to replace an outdated p.c. Despite the fact that you get more memory and hot new features, the BLS doesn't factor in the residual value of your old unit and the fact that it has a relatively worthless resale value.

Strickland points out that the largest component to the CPI index is housing. The official data cites a 17% increase in the housing index since 1999. However, the agency that monitors mortgage giants Freddie Mac and Fannie Mae, OFHEO reports a 44% increase at the same time. If they are more accurate than the BLS it would materially understate the inflation index.

Money Traders Feel the Pressure

The specter of rising prices is not simply a figment of the imagination of doomsayers who tell us that soaring budget deficits will cause bond yields to rise dramatically. In recent weeks bond traders have abandoned bonds forcing yields to break out of their six-month range. Since September 2004 the yield on the ten-year U.S. government note has fluctuated between 3.72 - 4.42%. Last week rates were close to 4.60% causing traders to cut loss making positions as well as boosting the cost of funding the runaway budget deficit through higher interest rate costs.

Nor is it simply bond prices where traders are nervous. Money traders too have had to rethink quite where the Fed might need to push rates to before they are finished tightening the corset.

Going into the recent election in October late last year, dealers were significantly more optimistic about what the Fed would have to deliver. At the time the implied rate of 3-month money at the end of 2005 was a mere 3%. The year-end rally in stocks coupled with strengthening fourth-quarter earnings as well as the pick-up in merger and acquisition activity has set a more positive economic tone. The ongoing saga of a weaker dollar has only added fears of a more aggressive stance by the Fed. Last week traders had pushed the December 2005 eurodollar future to an implied rate of 4.17% or a whole 1.17% higher than less than six months ago.

Far from Neutral

When you consider that the current rate of inflation is at 3% a Fed Funds rate of anything less than this is still actually considered expansionary. In other words monetary policy is still encouraging investors to borrow in order to take on capital projects in the knowledge that the rate of inflation is above the cost of capital. Only when rates exceed the current inflation rate, or rather the projected rate of inflation, is policy setting said to be normal. When you consider further that 'normal' has in the past seen interest rate 3% or more above the CPI inflation rate, you can begin to see precisely why bond and money managers are more and more edgy going into this meeting. When you consider that Fed Chairman, Alan Greenspan recently admitted that at some stage the Fed would need to remove the 'measured pace' language, the pressure mounts.

Half PerCent Hike a Possibility

To that extent a half-percent move today might have been appropriate. Despite the immediate market shock, dealers would be left to conclude that as long as the accompanying statement said that the Fed had not changed its mind about the medium-term inflation profile and that such a move was aimed at removing uncertainty, it might actually spur the stock market into believing that the end to policy tightening would be coming sooner than they'd originally thought.

As it is the interest rate market has laid it bets on the table for all to see. They reckon that the most likely scenario before the end of 2005 is for the Fed to keep on dishing out the medicine in quarter-point increments at each of the six remaining FOMC meetings this year. That would be enough to take rates to 4.25% by year-end without upsetting the market further. As the Bard of Avon, William Shakespeare put it so well in 'Macbeth,' "If it were done when 'tis done, then 'twere well it were done quickly."

No Let Up in Commodity Price Pressures

With signs of temperate inflation at the mall and with greater pressures with potential to manifest over the future months, investors are just beginning to become savvy as to the power of that unusual asset class known as commodities. Typically priced in dollars, these raw materials can cover commonly known energy contracts such as crude oil and natural gas as well as typical agricultural contracts such as wheat or cotton.

Because they are priced in dollars, there price tends to increase as a store of value when the dollar is down on its luck. That's because commodities are an asset class in their own right. Grains, copper, frozen orange juice or hogs can be used to store wealth. When investors hold bonds or stocks they can leave them at the bank or in a safe deposit box. Holding raw commodities can be hazardous if it involves shipping, storage or insurance of a physical crop and so many investors simply stick to holding funds of commodities or better still, commodity futures. That way they are guaranteed to get in on the action but do not have to bare the smell of hogs around the home.

Gas Prices Pushing Commodity Index Near Record

Commodities at large have been going through a bull market recently. Take a look at the price of a gallon of gas at the pumps if you haven't filled up. The latest Lundberg Survey of gas prices puts gas prices at $2.13 a gallon - a record in nominal terms but less than the inflation adjusted $3 per gallon reached in 1981.

Massive increase in fundamental demand has been brought on by a surging Chinese economy at a time when the U.S. economy has been on the mend. The coincidence of needs has served to push base metal, agricultural and even shipping costs to a premium forcing commodity prices higher across the board. This is where producer prices begin to heat up causing basic inflationary pressures. The ensuing strength of the economy will determine whether the fans are flamed and price rises are pushed on to consumers.

Proof that this commodity bull markets has some real legs to it comes to us through the Commodity Research Bureau's bellwether commodity index known simply as the CRB index. In the years following the toppling of the Shah of Iran, which laid the foundations for the huge surge in the price of oil, the CRB index hit a 1980 high of 334.80. The index covers a basket of base metal, energy and agricultural products. The index hit a multi-year high on March 16, 2005 when it roared ahead to 322.42. Clearly within striking distance of its all-time high investors continue to pour money into commodity futures and funds.

The ultimate store of wealth is gold, although in some parts of the world it is commonly accepted as a currency while in others it is used as a ritual and commonly accepted gift between families. It has increased in value as the price of the U.S. dollar has fallen over the last couple of years itself hitting a high point at $460.30 in December 2004. Since then and despite continued dollar woes, the precious yellow metal has put in a disappointing performance.

While you may have already felt in advance the stock and bond market worries and reaction to Tuesday's Fed rate move, one are that might not yet have felt the pinch is the housing market. Ever since the stock market peaked in 2000, real estate picked up the reins and led the charge off into the sunset. Led on by investor equity market liquidations and fuelled by surging bond prices, investors sought higher real-rates of return turning the housing market red-hot.

Many homeowners have locked into rising interest rates by taking out a fixed rate mortgage. That leaves them immune to Fed policy gyrations. New home sales recently peaked at 1.3 million sales per month. The latest data showed a decline, but it's not as if the market is falling off a precipice. It will be a long day before real-estate investors are turned off speculating to flip a house before it's even built. Similarly, sales of existing homes are running at a very impressive pace part in thanks to the demographic pressures of a buoyant economy.

As the U.S. consumer finances more in order to buy autos, furniture or another home it's becoming clearer that household finances are becoming stretched. According to data available from the Federal Reserve, the consumer now devotes 13.3% disposable income to interest payments. That's more than the 11% at the start of the 1994 tightening cycle arguing that the consumer may well feel the pinch as the Fed continues to punish the binge.

The real answer will come later this year when we see how household finances stand up to holiday spending at the mall. In 2004 we were pleasantly surprised, but this year as real interest rates inevitably turn restrictive the Fed Governors will want to see whether the consumer became savvy and locked into fixed interest payments on mortgages or whether spending dries up in the face of monetary tightening. If it doesn't the Fed will likely find itself pushing on a shoestring as it tries to contain inflationary pressures, which might have become uncontrollably vigorous.


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While some analysts expected a half-point increase, the Fed opted for a more conservative approach. Its quarter point increases have become standard fare.On June 30, 2004 the Federal Reserve announced its first tightening in monetary policy since May 2000 by raising the Fed...
Tuesday, 22 March 2005 12:00 AM
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