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No Change in Fed Policy Likely, Stock Prices Should Continue Rising

Prof. Peter Morici - 12/20/2006

Yesterday, the Labor Department reported the Producer Price Index rose 2.0 percent in November, after falling 1.6 percent in October.

In November, food prices rose 0.1 percent and energy prices rose 6.1 percent; however, the previous month, food and energy prices fell 0.8 percent and 5.0 percent, respectively

Core producer prices—producer prices less food and energy—rose 1.3 percent in November, after falling 0.9 percent in October.

Even when food and energy prices are removed from the index, producer prices are much more volatile than consumer prices. The November increases in producer prices should not be viewed with alarm, because of past monthly declines. Over the last year, producer prices, including food and energy, have risen only 0.9 percent, and consumer price inflation is likely to moderate through the early months of 2007.

The Federal Reserve will want to see several more months of data before changing interest rate policy, and no change is likely at least until the March 27-28 meeting of the Open Market Committee. My quarterly forecast does not build in an interest rate change until the May 10 meeting.

Growth should moderate to about 2.1 percent in the fourth quarter and rebound to near 2.5 percent the first half of next year.

Some consumer optimism will be needed to power this recovery, as the fall in housing starts is likely to weigh down growth through the second quarter.

Prices for new and existing homes have moderated, not collapsed, and overall these have risen about 55 percent over the last five years. Recent adjustments in existing and new home prices should be viewed as healthy, reining in speculations in land values. Once completed, these adjustments should help establish the framework for price stability, and healthier growth less dependent on property speculation and borrowing.

Gasoline prices are rebounding a bit in December but are not climbing to the menacing levels seen last summer. Overall, more moderate energy prices are cushioning the effects of the modest adjustment in home prices on consumers, and homeowners still have considerable untapped equity.

Falling energy prices, moderating inflation and decent holiday sales will further strengthen corporate profits and investor confidence. If the new Democratic majority in Congress does not spook the bond and equity markets with talk of aggressive new spending initiatives, taxes, or business regulations, the stock market rally will remain robust into the New Year.

Household savings performance will improve, and ordinary investors should shift from buying bigger homes to buying stocks. Also, a lower dollar against the euro and other currencies is sparking interest in U.S. equities.

Moderate inflation, stronger company fundamentals, and stronger demand from ordinary investors and from abroad should push stocks higher in 2007.