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Moderation in Core Rate Should Comfort Investors, Push Up Stocks

Prof. Peter Morici - 6/21/2007

Friday, the Labor Department reported that the Consumer Price Index rose 0.7 percent in May, thanks in large measure to rising energy and food prices. This was higher than expected but moderation in the core rate of inflation should comfort investors. Energy prices rose 5.4 percent in May after rising 2.4 percent in April. Tight refining capacity and scattered emergency closures have run down inventories. Gasoline supplies will remain tight and prices will likely continue head up further.

Food prices were up 0.3 percent after rising 0.4 percent in April. Rising food prices are exacerbated by the ethanol program, which is pushing up the prices for grains and derivative products like poultry, beef and baked goods to supplement imported gasoline supplies. Federal policy is clearly pushing up food prices to cope with oil import dependence.

In May the core CPI—consumer prices less energy and food—rose 0.1 percent, after rising 0.2 percent in April.

Food and energy prices are quite erratic from month to month. These are much less affected by U.S. economic conditions and Federal Reserve interest rate policy than other segments of the economy. Consequently, Federal Reserve policymakers pay close attention to movements in the core index.

Since May 2006, core consumer prices have risen 2.2 percent, and the compound annual rate of change for the three months ending in May was 1.6 percent.

Higher energy prices, so far, have not much penetrated core consumer prices, and the latest surge in energy prices should ease by September. Core consumer price inflation will remain near the upper end of Ben Bernanke’s target range of one to two percent a year at bit longer.

Lasting relief from this inflation is not likely before fall of this year.

No Change Likely in Federal Reserve Interest Rate Policies

In May, gasoline prices rose 10.5 percent. More automobiles and more horsepower in the vehicles Americans drive are pushing up gasoline demand, while supplies of refined products remain relatively stagnant domestically and scarce globally.

U.S. refining capacity and stocks are stretched thin by rising domestic demand and U.S. environmental policies, and pressures from export-driven growth and inefficient petroleum use in China and elsewhere in Asia soak up additional overseas supplies as those come on line.

U.S. gasoline stocks are below 2006 levels, and this summer the average price of gasoline could easily rise above $3.50 a gallon, nationally, and $4.00 a gallon in California. Currently the average price is $3.12 per gallon, nationally, and $3.37 in California.

Surging gasoline prices will pressure consumers to go deeper into debt. Drivers my get headaches from $75 dollar fillips, but consumers strapped by higher gasoline prices will either have to borrow more or spend less. My bet is they will borrow more through the summer.

Inflation hawks within the Federal Reserve can offer Chairman Ben Bernanke few effective options other than to ride out gasoline price inflation. U.S. environmentalists and Democrats in Congress will not abide new refining capacity, and it cannot be brought on line quickly. The ethanol program is a high-cost, low growth solution to dependence on foreign oil. It appeals to farm state senators, but it is a very costly and inefficient approach that raises food prices to create expensive gasoline.

Similarly, China’s petroleum consumption is rising very rapidly, as its growing manufacturing sector uses petroleum and electricity much less efficiently than U.S. competitors. China’s undervalued yuan is driving growth much more than low cost labor, and the resulting shift in industry to China is pushing global energy prices to painful levels and making China the number one polluter on the planet.

Only radical adjustments in Chinese exchange rate policies and export strategies, which Treasury Secretary Henry Paulson and President George Bush appear unwilling to accomplish, could quell pressures on global and U.S. energy markets. By giving China a pass on its undervalued yuan and export subsidies, the Bush Administration has significantly limited Federal Reserve capacity to affect U.S. energy prices and control the broader measures of inflation. This situation is likely to get worse before it gets better. The U.S. economy will grow slower and Americans will be poorer, because of Bush-Paulson China policy.

Despite higher gasoline prices and the housing slowdown, consumer spending for non-energy items, including automobiles, is growing moderately. Home prices are still up 55 percent from five years ago, and stock market values are up about 20 percent from last August. The economy should be able to deliver first half growth in the range of 1.8 to 2.3 percent.

The Federal Reserve may not be able to accomplish both moderate inflation and reasonable GDP and employment growth. Faced with choosing between instigating a recession or an inflation spiral it cannot much slow, the Federal Reserve will opt to do nothing and that is the smart choice.

Cutting interest rates now won’t jump start the economy, because the housing adjustment and gasoline price surges must run their course. However, cutting interest rates now would drive prices higher next winter to no good purpose.

These conditions severely test Ben Bernanke’s judgment and patience. What he says will be as critical as his actions. He must calm financial markets and define for politicians the true impediments to price stability and robust growth if he is to succeed.

Sooner or later Ben Bernanke must focus the Congress and Administration on the inflationary pressures and constraints on growth imposed by U.S. energy policies and Chinese currency, trade and energy policies. If Bernanke does not refocus the Congress on energy policy and the real problems created by Chinese mercantilism, the tradeoff between U.S. inflation and slower growth will worsen, and Federal Reserve policy options will grow less pleasant.

Look for no change in Federal Reserve interest rate policy before at least September, slow GDP growth to continue until the third quarter, and a continued surge in inflation. In the second half, growth should improve somewhat, but inflation could remain a worry, largely driven by China’s growth, appetite for oil and protectionist currency policies.

Outlook for Stock Prices

Moderate growth and stable interest rates will further strengthen corporate profits and investor confidence. 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.

Large U.S. multinationals, earning significant profits in Asia, offer great opportunities for Europeans and Japanese investors, who sit on strong euros and pounds but have few good investment options at home.

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

Inflation concerns will create periodic hiccups, as those did earlier this week. The ride may not be smooth but the direction is clearly upward. The Dow is headed for 14,000 by yearend.