THAT BLIP ON THE RADAR SCREEN ISN'T INFLATION
When inflation sneezes, the bond market catches a cold. A couple of ah-choos from consumer and producer prices recently gave bond prices the chills, causing a sharp rise in long-term interest rates. But fear not. There is no dread inflation disease going around. When the bond market realizes that, long rates will head back down.
Bond folk have good reason to be skittish. The super-rally in bond prices, fueled most recently by the promise of deficit reduction from Washington, had sent the rate on 30-year Treasuries into a dizzying decline of a full percentage point in four months, to 6.7% in early March.
After such a huge rally, some backing up seemed inevitable. Worrisome increases in the February price indexes, along with rising commodity prices, supplied just the right jolt. By mid-March, the yield had jumped back up to 6.9%. That may not seem like much, but if sustained, it could cost the economy some $20 billion in stimulus over the next couple of years.
The trouble began on Mar. 12, with an unexpectedly large increase of 0.4% in the February producer price index for finished goods. The core PPI, which excludes food and energy, rose 0.3%, after a disturbing advance of 0.4% in January. Inflation at the earlier stages of processing also showed some acceleration.
These numbers heightened the anticipation of the Mar. 17 report on the February consumer price index. The CPI rose 0.3%, about as expected, but the core CPI looked less reassuring. It posted a second consecutive increase of 0.5%, further fueling concern that inflation might be picking up (chart).
The bond market seems to be worried that rates have come down too far, too fast. But despite the latest round of numbers, fear of inflation is the wrong reason to turn bearish. Take commodity prices. True, the Journal of Commerce and Commodity Research Bureau indexes are both up, but the increases have been narrow and relatively small.
Although firmer commodity prices are typical as economic growth picks up, neither the JOC nor the CRB index has climbed to worrisome levels. Lumber and oil account for much of the recent rise. Lumber prices have surged largely because of unusually rainy weather in the Northwest and because policies to protect the spotted owl have reduced available woodlands. Oil prices are also up, but recessions in Europe and Japan will keep world oil demand weak and frustrate OPEC's efforts to lift prices.
Moreover, the recent spasms in consumer and producer prices do not reflect the underlying trends in both retail and wholesale prices. Those trends are determined by the growth of overall demand and production costs, neither of which is sending up any red flags.
In fact, it's just the opposite. Although the expansion is now on firm footing, the pace of demand is far from robust. Judging by the latest data on retail sales, consumer demand is slowing down this quarter. Retail sales rose a modest 0.3% in February, after no growth in January. So far in the quarter, retail buying is rising at an annual rate of 3.5% from the fourth-quarter level. That's down from the 12.5% pace racked up last quarter (chart).
In these more cautious post-holiday months, shoppers may be balking at higher prices. For example, retailers lifted clothing prices by 1.5% in February, after a 0.8% hike in January, according to the CPI report. But consumers left the apparel on the racks. Clothing store receipts fell 0.3% in January and then 1.7% in February.
You can expect the Blizzard of '93 to take a toll on the March retail sales data--not to mention the numbers for prices, income, construction, output, and jobs. The century's most severe winter storm caused store closings and other losses and disruptions from Florida to Maine during the weekend of Mar. 13-14. According to the Johnson Redbook Report, weekly retail receipts plunged.
Looking further back in the pipeline, the modest pace of demand means that producers will find few opportunities to pass along price increases to retailers. Although February's jump in producer prices alarmed the bond market, it looks more like an aberration than a trend. Price hikes on a few items--heating oil, tobacco products, and cars--accounted for much of the runup. Inflation at the producer level remains very tame, with prices of finished goods up just 1.8% in the past year.
Moreover, recent output gains are too modest to trigger capacity bottlenecks that could lift prices in a big way. Industrial production rose by 0.4% in February, the fifth straight advance (chart). Manufacturers lifted output by 0.3%, with big gains in computers and appliances. But operating rates for all industry rose to just 79.9% in February, from 79.7% in January. Capacity usage will have to close in on the 83% mark before producers begin to face production constraints.
The blizzard likely crimped output in March, but the industrial sector had a solid first quarter. Even if March output is flat, industrial production would still grow at an annual rate of more than 4% for the quarter. That pace is strong enough to generate jobs, but not robust enough to raise inflation worries.
In addition, although inventories remain low, there are no broad signs of shortages that tend to push up prices. Inventories held at manufacturers, retailers, and wholesalers were unchanged in January. And the ratio of inventories to sales remained at its 11-year low of 1.46. Inventories do look skimpy in manufacturing, but part of that reflects factories' long-term adjustment to just-in-time inventory control.
From businesses' point of view, cost pressures that could drive price hikes are generally absent. The growth of unit labor costs, which largely determines the floor under price growth, slowed to 0.4% last year. That was the slowest annual pace since 1965, when inflation was running at less than 2%. With further productivity gains likely, and with any sharp rise in wage growth unlikely, unit labor costs are certain to remain tame in 1993.
The overriding economic fact is this: With so much labor and capital going unused right now--both at home and abroad--sustainable price pressures cannot take hold. Currently, real gross domestic product is some 4% below where it would be if the economy's resources were fully utilized. In that situation, it could be years before inflation is capable of any lasting acceleration.
One exception to the low-inflation rule is lumber. Shrinking supplies and growing demand caused by the two-year-old housing upturn have raised the cost of wood products to record levels.
In February, the wholesale price of softwood used for construction jumped 9.4%, on top of 6.9% increases in December and January. More expensive lumber will add to the price of a home, even as lower interest rates reduce mortgage payments. Rebuilding after the March storm damage could add more price pressure.
Rising costs may be one reason for the pause in homebuilding. Housing starts eked out a 2.5% gain in February, rising to an annual rate of 1.21 million. But they had plunged 8.4% in January, and housing has been about flat since August (chart).
The Blizzard of '93 likely slammed homebuilding into the ground for March. That decline, however, will set up the likelihood of a very busy April and May as builders rush to make up for lost time. That's especially likely if the bond market comes to its senses soon and renews its rally. If so, mortgage rates could decline further.
Indeed, the entire economy would be better off if the bond market shook off its malaise. The market's inflation-hypochondria isn't about to derail the expansion. But if it gets worse, higher long-term interest rates could mean the difference between a healthy economy and one that needs a warm blanket and chicken soup.James C. Cooper and Kathleen Madigan