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Inflation Remains the Key Variable
The data don't gel with the Fed's (new) dovish tone.


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David Malpass

The Federal Reserve hiked its overnight rate on Thursday to 5.25 percent from 5 percent. The accompanying statement said inflation expectations are contained and that any additional firming will depend on inflation and growth. Although equities and bonds rallied on the news, the dollar weakened on the Fed’s dovish tone. Gold hit $600 per ounce, and is now up 38 percent year-over-year. Though I’m not a fan of the TIPS spread (nominal yield minus real yield), I note that it widened after the release of the Fed’s statement. TIPS’ inflation expectations jumped.

 

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I believe that inflation is the key market and economic variable today. While I do expect core inflation measures to rise, should they stay at current levels the economic outcome will be very good. In effect, the Fed will have achieved a soft landing in which the extreme monetary stimulus of 2004 supported the economy and weakened the dollar without causing too much inflation. Equities would be right to celebrate.

 

That said, I was surprised by the Fed’s statement. The Fed worked hard in June to increase the awareness of the inflation risk, causing interest-rate expectations to rise. But the June 29 statement went in the other direction: “Readings on core inflation have been elevated … Economic growth is moderating … the moderation in the growth of aggregate demand should help to limit inflation pressures …”

 

The Fed noted the “quite strong pace (of growth) earlier this year,” which understates the 5.6 percent real GDP growth and 8.9 percent nominal GDP growth of the first quarter. Since the Fed is linking growth to inflation, it’s important to correctly factor in the strong starting point for the moderation.

 

The most recent data on corporate profits (up 28.5 percent year-over-year in the first quarter, the fastest 12-month growth since 1984!) underscores the economy’s strength. Some argue that profitable companies won’t raise prices, but I’m skeptical given the weakness of the dollar (which encourages even profitable companies to raise prices).

 

So my concern is that inflation is likely to rise even higher if the value of the dollar stays at its current (weak) level. We’ve already had substantial inflation in commodities, the producer price index, the consumer price index (4.7 percent year-over-year in September 2005; still 4.1 percent in May 2006), the GDP deflator, and the core GDP deflator. Core CPI in for the March-to-May period rose at a 3.8 percent annual rate.

 

The dollar is weak. Since the end of 2001, euros have gone up 42 percent, yen 14 percent, and gold 119 percent. This puts upward pressure on prices just as the strong dollar of 1999 and 2000 put downward (deflationary) pressure on prices.

 

Wages also add to the inflation story. Average wages rose 3.7 percent year-over-year in May, reaching $16.62. We all like wage gains, but I believe they will add to core inflation.

 

I don’t agree with the Fed’s sense that inflation expectations are contained. The best indicator is gold, which, at $600 per ounce, is 72 percent above its 10-year moving average. The market prefers gold to a 5.25 percent yielding U.S. dollar, a strong vote against the dollar and in favor of inflation.

 

– David Malpass is the chief economist for Bear, Stearns.



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