Inflation Heats Up in April

A higher-than-expected reading for the core producer price index raises fresh worry among economists. Will the Fed's next move be a rate hike?

by BusinessWeek, Standard & Poor's, and Action Economics staff

Financial markets received a jolt on May 20 after a hotter-than-expected reading on a widely watched measure of wholesale inflation in April. The headline producer price index (PPI) rose 0.2% in April, but the core PPI, which excludes food and energy prices, rose 0.4%. The consensus estimate of economists was for the reverse: 0.2% for the core rate and 0.4% for the total.

U.S. stock indexes slumped on May 20 after the release of the report, as inflation-wary investors headed for the exits. Of the major U.S. market benchmarks, the blue-chip Dow Jones industrial average was the worst performer, sinking nearly 200 points, or 1.5%, on the session. Treasuries rose on the back of a flight to safety out of equities, while the dollar declined vs. other major currencies.

Some of the data points in the report were counterintuitive, to say the least. Energy prices dropped a surprising 0.2%, while food prices were flat after a 1.2% March jump. Energy prices rose 2.9% before seasonal adjustment, and are up 17.5% year-over-year, but the April rise is less than the normal seasonal increase. Food prices are still up 5.2% from a year earlier.

Fed Concerns: Inflation Eclipsing Growth

Two sets of numbers contained in the report caught economists' attention. Intermediate goods prices, which reflect crude materials that have had some processing, rose 0.9% (1.2% excluding food and energy), despite a moderate 0.5% rise in energy costs. Crude materials jumped 3.2% (7.9% excluding food and energy).

The big increases in the core intermediate and crude price indexes suggest more inflation in the pipeline, according to S&P Economics.

"The only 'solace' in these horrendous figures is the fact that the financial markets have already largely digested the idea that producer prices are rising rapidly, a fact that can't be missed when watching commodities prices on a day-to-day basis," wrote Tony Crescenzi, credit market strategist for Miller Tabak in New York, in a May 20 note.

"Soaring prices will keep the Fed hobbled despite growth concerns and troubles in the credit markets, as is indicative of the Fed's shift to a neutral posture at the last FOMC [Federal Open Market Committee] meeting," says Action Economics. The May 21 release of the April FOMC minutes should reveal significant upward revisions to the Fed's personal consumption expenditures (PCE) chain price forecasts, says Action Economics, just as it shows downward revisions in its growth forecasts. "[W]e may find that the inflation problem has a greater shelf life than credit market and economic woes."

The 0.4% rise in April core PPI, along with the medium-term inflation expectations reading from May's Michigan consumer sentiment report, is likely to seriously trouble the Fed on the inflation front, according to Bear Stearns (BSC) economist John Ryding. "Given the inflation story, it is looking increasingly unlikely that the Fed will cut rates again in this rate cut cycle," he wrote in a May 20 note.

What does the market see ahead for interest rates? Action Economics says fed funds futures prices reflect the likelihood of a steady FOMC rate stance through the summer, but a 40% chance of a 25-basis-point rate hike by the end of the year.

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