Many Signs Pointing to Higher Inflation
For most of the last 20 years Americans were advised to fear the return of inflation. It always seemed to be around the next corner.
Over the last 12 months the opposite threat suddenly has appeared to loom large: deflation, meaning a broad-based decline in prices.
Now what? Financial markets are struggling to reach a logical conclusion about inflation’s next move. For many investors the stakes are high. Even a modest turn upward in inflation could slam the portfolios of people who have large sums in low-yielding bank savings accounts or Treasury securities.
A slide into widespread deflation, by contrast, could slash corporate earnings and send stocks to new lows.
The government’s report last week on 2002 trends in the consumer price index painted a mixed picture of inflation. Prices of many goods, especially clothing and cars, deflated in November and December amid aggressive discounting to lure shoppers. But prices of many consumer services continued to rise in 2002, boosting the CPI services sub index 3.3%, down marginally from a 3.6% increase in 2001.
The CPI trends were somewhat mixed a year ago as well. What is different now is that key government and market forces are pushing hard in the same direction: to turn the tide in favor of rising prices.
Those forces are too powerful to bet against, many experts say. So their advice to investors is to structure long-term portfolios accordingly -- thinking about which assets would benefit from an uptick in inflation (real estate and stocks, for instance) and which would be hurt (in particular, low-yield fixed-rate bonds).
“My guess is that if we want inflation, we will get it,” said Susan Sterne, economist at Economic Analysis Associates in Greenwich, Conn. And many more constituencies prefer higher inflation to the risk of a serious deflation, she said, because the latter conjures images of a collapsing economy and 1930s-style bread lines.
Analysts point to four major factors that are signaling higher inflation down the road:
The Federal Reserve is holding short-term interest rates at 40-year lows and has made clear it can do even more to stimulate borrowing and spending if that’s what is needed to spur the economy and keep the general level of prices from eroding.
In the fourth quarter, Fed officials conceded that they were concerned enough about deflation to discuss what steps they might take to combat a pronounced trend of falling prices.
Their discussions might become more heated: The “core” CPI index -- price changes excluding the volatile food and energy components -- rose 1.9% last year, tying the 34-year low set in 1999. Economists at Goldman Sachs & Co. in New York believe that deflation alarm bells go off at the Fed when the number is below 2%.
Fed Chairman Alan Greenspan told Congress in November that to battle deflation the central bank could launch a massive program to buy government securities from banks, flooding them with cash that would conceivably work its way into the economy.
Anyone who has taken a basic economics course knows that concerted “monetary” stimulus by the Fed is classic pump-priming for inflation: more money chasing after goods and services.
The Bush administration is pressing for an ambitious economic-stimulus program that would cut income tax rates for everyone and put more money in investors’ pockets by eliminating taxes on dividends.
Although many analysts question whether the dividend component qualifies as true stimulus, the scope of the plan -- which foresees deficit spending by Uncle Sam for years to come, in part to pay for the expected war with Iraq -- suggests the administration is serious about complementing the Fed’s stimulus campaign to keep the economy above water.
Historically, “wars and big government spending campaigns are how you get inflation,” said Paul Kasriel, economist at Northern Trust in Chicago.
The dollar is tumbling against the euro, the yen and other leading rivals. On Friday, the euro rose to $1.067, a three-year high. It has surged in value from 86 cents a year ago as more global investors have soured on U.S. assets, preferring to keep their money elsewhere.
Aside from ruining many Americans’ foreign vacation plans by raising the cost of overseas trips, a weak dollar is potentially inflationary because it makes imported goods more expensive as well, unless the suppliers of those goods choose to accept slashed profit margins.
If prices of foreign goods rise, U.S. companies that compete with the foreign firms also gain more flexibility to raise prices.
The government’s index of import prices, excluding oil, began to rebound last year after slumping in 2001 -- a sign that the falling dollar is having the usual inflationary effect.
Prices of major commodities have risen sharply during the last 12 months, driving the CRB/Reuters index of 17 key commodities up 27%.
The gain in the index partly reflects the jumps in oil and gold prices sparked by war worries. A weak dollar also helps inflate commodity prices. Still, the rally has been broad-based, lifting prices of raw materials such as rubber, cotton and steel scrap.
The gains suggest the recovery of the global industrial economy is proceeding apace. And as raw materials prices rise so does the potential for goods producers to try to pass on those increases to customers.
Admittedly, last week’s economic and corporate earnings reports didn’t do much to bolster the case for an improving economy. The government said U.S. industrial output fell in December. On the earnings front, disappointing outlooks from Microsoft Corp. and IBM Corp., among others, pushed the stock market lower, driving the Dow Jones industrial average down 2.3% for the week, to 8,586.40.
Nonetheless, Kasriel argues that investors who don’t expect the world to end anytime soon ought to be betting that the stage is set for a turn-up in inflation in a year or two, to possibly 3% or 4%. That could be good for corporate pricing power, earnings and the stock market, he said, but bad for Treasury bonds.
Some analysts believe the greater risk remains deflation, not inflation. Steve Roach, an economist at Morgan Stanley in New York, said the global economy remains mired in a “post-bubble period of excess supply and depressed demand.”
In that kind of environment, he said, even the “mother of all stimulus packages” is unlikely to gain much traction. He still believes the trend in prices of many goods and services is down.
Tom Petruno can be reached at tom.petruno@latimes.com.
