Coming Soon to an Economy Near You: Inflation

Like the mammoth alien spacecrafts casting their shadows over the world’s cities in the current movie blockbuster “Independence Day,” so the shadow of rising inflation has slowly crept over U.S. financial markets this year.

With Friday’s stunning June employment report showing yet another surge in new jobs--and a record 0.8% rise in average hourly wages during the month--Wall Street may have suspended the last bit of disbelief over the economy’s resilience and what that may mean for inflation in the near future.

Granted, there weren’t too many players in the markets Friday, given the holiday weekend. But those present were clear about their outlook for inflation and interest rates now, sending the benchmark 30-year Treasury bond yield rocketing from 6.93% to 7.19% and the Dow Jones industrial average down 114.88 points to 5,588.14, the lowest since mid-May.

If this all seems like deja vu, it should. The monthly job reports have repeatedly sent bond yields surging this year, and the February report, released March 8, was responsible for a 171-point plunge in the Dow that day.

But each time that the employment data suggested a healthier economy and growing inflationary pressures, many Wall Street pros scoffed, contending that the numbers were fluky. “Wait till next month,” they’d say.

Likewise, the government’s monthly consumer price index reports have shown that, by that measure, the U.S. inflation rate so far this year is running at an annualized rate of 4.1%, well above the 2.5% rate of 1995.

Skeptics have argued that the CPI has been skewed by temporary increases in gasoline and food prices and that the “core” rate of inflation remains tame.

But that’s like saying there is no increase in inflation just so long as you don’t eat or drive. Know anybody who qualifies for those demographic groups?

There have been other consistent arguments against a sustained upturn in wage and price inflation as well. People don’t feel that their jobs are secure, so they have no bargaining power with employers. Companies can’t pass along price increases because the world economy is too competitive. Productivity gains will allow businesses to swallow higher costs without boosting prices.

All true, to an extent. And still, the numbers this year show that somewhere out there in the giant U.S. economy more people are getting bigger raises, and the costs of some goods and services are rising faster than in 1995.

David Dreman, veteran money manager at Kemper/Dreman Asset Management in New York, says those investors who have assumed that inflation had simply disappeared from the financial landscape were harboring “ludicrous” expectations. “To have an economy with full employment, rising [gross domestic product] and all these good things, but no inflation--well, it ain’t never happened,” he says.

So with Friday’s June employment data, it seems clear that more investors now will have to confront two of their deepest fears: That the days of super-low inflation are over, at least for the time being, and that the Federal Reserve Board has absolutely no choice but to begin tightening credit again to slow the economy and thus attach an anchor to the inflation trend.

Let’s be very clear on one point: Nobody is talking about a return to the 13% annualized inflation rate of the late-1970s. In fact, nobody’s even talking about half that rate.

But U.S. consumer price inflation has been subdued for so long--under 3% annualized each year since 1992, and declining almost continually since 1980--that the thought of even a 4% sustained annual rise in prices is potentially shocking to financial markets.

Similarly, annual average hourly wage inflation plunged from a 4.5% rate in mid-1989 to nearly 2% in late 1993, and has been only creeping higher since, before breaking decisively above 3% this year. The June employment report pegged wage growth at a 3.4% annual rate, highest since 1991.

For Wall Street, the idea of higher inflation really is like an alien invader come to town: Investors aren’t quite sure how to react (who remembers the 1970s?) but they know enough to realize that this alien brings some kind of new risk to the situation.

Why do financial markets hate rising price inflation? Because it cheapens the value of money and financial assets. Thus, bond yields rise because investors want to be guaranteed a decent after-inflation, or “real” yield on their money. And stock prices aren’t worth as much because investors question the true value of future earnings and dividends, if higher inflation is going to erode them.

Then there is the fear of the vicious cycle come again: If companies and individuals adopt an inflation mentality, the former may feel emboldened to pass through more price increases, and the latter may feel emboldened to demand ever-higher wages. The result can be an inflation spiral that becomes extremely difficult to halt.

That is why Wall Street, once again, is looking to the Fed, which is supposed to be the nation’s principal inflation-fighter. By tightening credit in the economy--driving short-term interest rates up--the Fed, in theory, can brake the economy and restrain inflation.

But the Fed has restrained itself this year, allowing the economy and inflation to pick up without officially boosting interest rates, because the central bankers (like everyone else) have wanted to believe that it was only a matter of time before growth slowed, and inflation ticked down again.

Now, however, “I think there’s got to be a major sea change down at the Fed,” says economist James Glassman at Chase Manhattan in New York. By delaying showing true resolve against inflation, the Fed has risked getting behind the curve--meaning that any interest-rate hikes may be too late to stop inflation that’s already in the pipeline. “If you wait until you have a solid case for inflation [in the economic data] it usually is too late,” Glassman says.

Yet the Fed’s situation is complicated by some political realities. It’s an election year. And more important, the public may be royally incensed at the thought that, just as wages begin to go up meaningfully, Fed Chairman Alan Greenspan will choose to raise interest rates and crush the economy and wages once again.

The Fed will say it’s merely trying to extend the economic expansion by keeping growth, and inflation, on an even keel.

But the debate has never been more intense, or more global. The world wants faster economic growth, and more jobs. Who’s to say how much growth is too much? Who’s to say that faster growth will necessarily lead to wage and price inflation much above current levels? Is a little more inflation worth the cost, if it means creating more jobs for Americans, Germans, Chinese, Indians, et al.?

“Hourly workers have been waiting for some time to participate in this buoyant economy,” Labor Secretary Robert Reich said Friday, in what sure sounded like a veiled hint to the Fed.

For financial markets, the next few months may shape up like so: For the shell-shocked bond market, there will be an assumption that either the Fed is going to tighten credit, or inflation is going to continue to rise, or both. It’s hard to envision lower interest rates given those assumptions, and far easier to assume higher yields, unless the economy is about to come crashing down.

For the U.S. stock market, which has managed to turn every bit of bad news into good news this year, there are two possibilities now: Either we get a meaningful sell-off soon (i.e., that long overdue 10%-or-worse drop in major indexes like the Dow), or the market somehow holds together and glides ahead, in which case we truly are in a new, golden investment era never before experienced by mankind, nor, probably by aliens either.