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

Prof. Peter Morici - 7/19/2007

Yesterday, the Labor Department reported the Producer Price Index fell 0.2 percent in June, after rising 0.9 percent in May. For June, the consensus forecast was 0.2 percent, and my published forecast was 0.0 percent.

Energy prices fell 1.1 percent, after rising 4.1 percent in May. Food prices fell 0.8 percent, after falling 0.2 percent in May.

Core producer prices "producer prices less food and energy" rose 0.3 percent in June, after rising 0.2 percent in May.

Over the last year, producer prices have risen 3.3 percent. Producer prices excluding food and energy rose only 1.7 percent; however, the May and June surges in core producer indicate higher energy prices and slower productivity growth are filtering through to the wholesale prices businesses pay. This bodes poorly for bringing core consumer price inflation down below Federal Reserve Chairman Ben Bernank's target of 2 percent.

International oil prices continue to surge, and gasoline and heating oil prices are likely to head up again soon. Despite a slow economy, the threat of inflation remains apparent, and the Federal Reserve can do little to affect conditions in international oil markets.

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.

Stable interest rates will be good for the stock market.


Outlook for Consumer Prices, Growth and Fed Policy

In June, gasoline prices and heating oil fell 6.7 and 0.4 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.

U.S. gasoline and distillate stocks are below 2006 levels, and gasoline and heating oil prices are likely to move up. Higher prices for gasoline and other fuels will continue to pressure headline measures of producer and consumer price inflation.

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.

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. Corporate profits will outperform the U.S. economy and the expectations of economists and Wall Street analysts, because many large U.S. companies are doing well in China and elsewhere in Asia.

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

Surging 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.