Wall Street and the Federal Reserve seem to have quite different views of the economy in 2007. Fed policymakers continue to send out warnings on inflation and the possibility of more hikes in interest rates. Market players aren't listening. They're not worried about inflation, and they expect the Fed to begin cutting rates at some point in the coming months. Meanwhile, investors are sitting back and enjoying the rallies that began in stocks and bonds last summer. Does Wall Street have it right?
So far, the chances look good, but both investors and the economy have a lot riding on the bet. If inflation is not as tame as the markets expect, and the Fed resumes its rate-hiking, bond yields and associated long-term rates for mortgages and corporate borrowing would climb. Higher borrowing costs would worsen the housing downturn and crimp corporate expansion. Plus, any market retrenchment would cut further into household net worth at a time when stock market gains have been a buffer against the waning support home values have offered to household wealth and consumer spending.
All this puts inflation smack in the middle of the outlook for the coming year, just when inflation prospects are especially unclear. Global competition remains an enormous restraint on U.S. prices, but the renewed decline in the dollar is likely to put some upward pressure on import prices. Oil and energy prices are creeping back up, but their future direction is still up in the air.
Plus, economists both inside and outside the Fed are unsure just how fast the economy can grow without fueling higher prices. Productivity gains, which helped keep a lid on inflation in recent years, have slowed sharply, and efficiency gains are offering less of an offset to rising labor costs, which could spur price hikes.
SO IS THE OUTLOOK for inflation really more worrisome than recent market trends suggest, or is the Fed just blowing smoke in an effort to protect its inflation-fighting credibility? The latest news from the prices indexes and from data on economic growth are coming in on the side of Wall Street. However, while there is mounting evidence that additional rate increases will not be needed, there is still little indication the economy has slowed enough to warrant rate cuts.
Both major gauges of consumer prices in November took a turn for the better after their upward trends through most of 2006. The overall consumer price index (CPI) and the Fed's preferred measure, the price index for personal consumption expenditures (PCE), each posted no gain from October, but the core indexes, which exclude energy and food, are what got the markets' attention, since the Fed tends to watch those closely. Both core indexes also held steady from October, and the annual trends of both are now headed down.
THE YEARLY INFLATION RATE for the core CPI appears to have peaked in September, at 2.9%, and it has since slid to 2.6% in November. The November softness vs. October was broad, although some price weakness, such as the declines in medical-care commodities and used cars, are unlikely to be repeated. Perhaps most significant, core service inflation, which makes up more than 70% of the core CPI, has edged down from a peak of 3.9% in September, to 3.7% in November. That's significant, since service prices tend to have a large labor-cost component, and they are more sensitive to domestic conditions and less so to global competition.
What's especially encouraging in the outlook for Fed policy and interest rates is the recent behavior of the core PCE price index, the measure favored by the Fed. In November, yearly inflation by this gauge continued to run above the Fed's unofficial 2% limit, but the steady runup in 2006 may well have peaked at 2.4% last summer. The rate dipped to 2.2% in November, marking the largest decline from the prior month since the first half of 2003. The pattern in recent months is even more favorable. Measured at a comparable annual rate, the rise in the core PCE index over the past six months is near the Fed's 2% limit, and the annual rate over the past three months, at 1.8%, is running safely under that limit.
THE INFLATION OUTLOOK and any future Fed action will come down to the strength or weakness of the economy. Given the recent favorable shift in the price indexes, the economic slowdown that began in the second quarter appears to be creating enough slack in the economy to allow pricing pressure to abate. Economic growth slowed to a revised 2% annual rate in the third quarter, after posting a modest 2.6% advance in the second quarter, and the housing downturn and cutbacks in orders and output needed to pare down excessive inventories are keeping a lid on growth.
Price discounting will help to cut those inventories, and other efforts to reduce stockpiles are reflected in softer factory activity. Orders taken by manufacturers of durable goods have slowed sharply in recent months, and excluding the ups and downs in the volatile transportation sector, orders in the fourth quarter are set to decline for the first time in 3 1/2 years. Manufacturing output is following that same track.The economy is far from weak, however. Look at the government's numbers on consumer spending. After adjusting for inflation, outlays posted month-to-month increases of 0.5% in both October and November. Those were the strongest back-to-back gains since the middle of 2005. Even if December buying shows no advance from November, spending still will have grown at a 4% annual rate from the third quarter, after only a 2.8% rise in the third quarter. That pickup will be enough to make a sizable contribution to overall growth, while helping businesses to unload some inventory.
Also, while more drag from the housing slump is on its way, the news on home demand is looking better. Sales of new single-family homes rose in November, reducing the inventory of unsold homes to a 6.3 month-supply, the fourth monthly decline in a row. And in December, builders' expectations of sales over the next six months continued to rise.
Heading into 2007, both inflation and economic growth are behaving pretty much as the Fed would like. If those trends continue, which looks likely, then investors stand a good chance of adding to their 2006 gains without fear that the Fed will spoil the party.
By James C. Cooper