Upward Pressure on Goods, Prices May Be Peaking

Bond yields posted one of their biggest one-day declines in years on Tuesday as government data painted a picture of a U.S. economy where consumers aren’t spending and inflation is muted.

The bond rally, and another surge in stock prices, indicated that the markets have shifted back to believing that the Federal Reserve Board will lower short-term interest rates soon--even though some Fed officials seemed to dash those hopes last week.

Perhaps more significant, some economists say the latest inflation reports suggest that the mild upward pressure on prices of goods and services over the past six months is peaking out.

That is important for the long-term health of bond and stock markets, because the threat of a sustained rebound in inflation--the scourge of the late ‘70s and early ‘80s--could easily undermine the bullish mood that has dominated Wall Street for most of this decade.

“Inflation never picked up much” as the U.S. economy expanded briskly in 1993 and 1994, says Bruce Steinberg, economist at Merrill Lynch & Co. in New York. Now, he notes, the economy is slowing sharply, which should serve to contain inflationary pressures still in the pipeline.

The government’s report Tuesday that retail sales rose just 0.2% in May--far below expectations--offered more proof that the wind has been knocked out of the economy.

In a second report, the government said the consumer price index (CPI) rose 0.3% in May, down from April’s 0.4% increase. And the “core” consumer inflation rate--changes in prices of goods and services other than food and energy--inched up 0.2% in May, half April’s rise.

Inflation is typically a lagging indicator, meaning it takes a long time to work through the system, from raw materials to finished goods to what consumers pay at the cash register. Price pressures have unquestionably been building in recent months, even as the economy has weakened.

The CPI, which rose 2.7% in both 1993 and 1994, is up 3.6% annualized so far this year. The core CPI rate is running at a 3.1% annualized rate, up from 2.3% through May of 1994.

Some economists argue that the rise in inflation, while on the surface appearing minor because the numbers still are so low, is alarming. Not only does every increase in inflation erode consumers’ purchasing power, but the declining trend in inflation in much of the world serves to make rising U.S. prices stand out.

“I think a 3.5% inflation rate today among developed countries is irresponsible,” says Robert Genetski, head of a Chicago economic consulting firm that bears his name. Moreover, he believes that the economy is stronger than it appears, and that a resurgence of growth later this year will lead to a CPI rise of 4% to 4.5% in 1996.

If he’s right, he adds, the stunning decline in bond yields this year may be vastly overdone.

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But many bond investors clearly are taking a much different view of the prospects for economic growth and inflation.

The steep plunge in longer-term interest rates on Tuesday--which pulled the yield on five-year Treasury notes down a remarkable 0.28 percentage point, from 6.15% to 5.87%--bespoke of a horde of investors still on the sidelines and eager to lock in yields on the assumption that the economy will stay weak and the Fed will cut short-term rates.

And overlaying those expectations, many analysts say, is Wall Street’s increasing faith that the longer-term outlook for inflation is benign.

In the late ‘80s a relative handful of bullish economists tried to convince investors that the catastrophic inflation of the late ‘70s and early ‘80s was a historical oddity, not a cycle that would be repeated soon. But many investors, remembering all too well the 13.3% CPI increase of 1979, shunned bonds and stocks on the assumption that it was just a matter of time before 1979 was relived.

Those fears returned in spades last year, as the economy boomed and the Fed doubled short-term interest rates to cool things down. In pushing long-term bond yields over 8% late last year, Wall Street appeared to be building in an assumed annual inflation rate of 6% or higher. The bond investor’s goal, of course, is to always earn a yield at least a couple points above inflation.

With long-term Treasury bond yields now nearing 6.5% again, it’s clear that investors’ inflation assumptions have again been slashed. And that’s only logical, many economists say.

Prices of many commodities, which rose last year with the economy’s advance, have pulled back. Gold’s price, a classic early-warning indicator of inflation, has been flat for more than a year. And the growth of the nation’s money supply, the inflation harbinger watched by many Fed critics, has slowed markedly.

Perhaps most significant, despite the economy’s growth for the past three years and a tight labor market in many parts of the country, wages aren’t rising much at all. Average hourly earnings of non-executive workers will rise 2.6% this year if they continue on their recent track. That would be down from 2.7% last year.

Without a surge in wage inflation, many economists argue that dramatic price inflation simply can’t happen. And in a global business world interwoven as never before--and never more competitive--the simple fact is that workers don’t have the ability to dictate wage gains.

That may not be a comforting thought for anyone who has to work for a living. But if that worker also happens to invest, a consolation is that low inflation and low interest rates are very comforting indeed for financial markets.

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No Raise, No Inflation?

Pay raises plunged in the mid-1980s and have remained low since--helping to dampen overall inflation. Annual increases in average hourly earnings of production and non-supervisory workers (private sector):

1995: +2.6%

Note: 1995 estimate is year-to-date change annualized.

Source: Labor Department

Consumer Prices

Percentage change, month to month, seasonally adjusted:

May 1995: 0.3%

Source: Bureau of Labor Statistics