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No Change in Federal Reserve Policy Likely, Stocks Poised to Rise

Prof. Peter Morici - 6/17/2007

Thursday, the Labor Department reported the Producer Price Index rose 0.9 percent in May, after rising 0.7 percent in April. For May, the consensus forecast was 0.6 percent, and my published forecast was 0.8 percent. Energy prices rose 4.1 percent, after rising 3.4 percent in April. Food prices fell 0.2 percent in May after rising 0.4 percent in April. Core producer prices "producer prices less food and energy" rose 0.2 percent in May after no change in April.

Over the last year, producer prices, including food and energy, have risen 4.1 percent. Through the summer, core consumer price inflation is likely to be above Ben Bernanke's target of 2 percent a year. Energy prices are moderating in June but will push up broader measures of inflation in July and August.

The clouded outlook for economic growth and risk of recession will check the Federal Reserve's inclination to boost interest rates. Look for no change in Federal Reserve interest rate policy through September and for the market for Treasury securities to stabilize.


Outlook for Consumer Prices, Growth and Fed Policy

In May, heating oil and gasoline prices rose 10.2 and 2.3 percent, respectively. U.S. refining capacity and stocks were already stretched thin by rising demand and environmental policies, and pressures from strong growth and inefficient petroleum use in China make additional global supplies scarce.

Both U.S. gasoline stocks are below 2006 levels. Although fuel prices are moderating in June, gasoline prices will likely move up again in July. The broad indexes of inflation will moderate in June, but rising fuel prices will push up inflation in July and August. Inflation will continue to worry the Federal Reserve.

Sadly, the policy levers at the Federal Reserve's disposal - higher short term interest rates - would do little to harness energy prices. Only new refining capacity, which U.S. environmentalists and Democrats in Congress will not abide, and radical adjustments in Chinese exchange and monetary policies, which Treasury Secretary Paulson and President Bush cannot seem to accomplish, could quell pressures on global and U.S. energy markets. By permitting China to undervalue the yuan and flood global markets with liquidity, the Bush Administration has significantly limited Federal Reserve policymaking prerogatives and forfeited those to China.

Higher gasoline prices will dampen growth in other spending. The combination of consumers reluctant to spend as uninhibitedly as in 2006 and builders stuck with too many unsold new homes will challenge the economy to deliver 2.3 percent GDP growth for 2007, as predicted by the Bush Administration. Growth in the range of 2 percent is more likely.

Federal Reserve policymakers face a difficult challenge accomplishing both moderate inflation and growth. Confronting a difficult choice between pushing the economy into recession or setting off an inflation spiral, the best policy course will be to do no harm, and leave the economy to its natural dynamics.

Look for no change in Federal Reserve interest rate policy before at least September, and equity and bond markets should calm from their recent panic concerning Federal Reserve intentions.


Outlook for Stock Prices

Moderate growth and stable interest rates will further strengthen corporate profits and investor confidence though a jaundice eye to inflation makes a bull stampede unlikely. Corporate profits will outperform the U.S. economy, because many large U.S. companies earn considerable profits in booming Asian economies.

With opportunities to expand U.S. operations limited, many U.S. companies will continue to buy back shares, and private equity funds will continue to buy and reorganize U.S. publicly traded companies. Both trends will continue to boost demand and prices for stocks.

Over the last 12 months, the dollar is down 8 percent against the euro. A weaker dollar makes U.S. equities a particular bargain for European and Japanese investors. Large U.S. multinationals, earning significant profits in Asia are a great investment opportunity for Europeans and Japanese who sit on strong euros, pounds and yen but have few good investment options at home.

Surging corporate profits, moderate growth and steady interest rates at home, and robust demand for equities from corporate buybacks, private equity, and individual and foreign investors should power up U.S. stock prices.