Inflation Fears

Near term, S&P doesn't expect inflation to be a problem, but the U.S. budget deficit must be addressed to prevent long-term price escalation

By Joseph Lisanti

Stocks have been weak recently, we believe mainly because of fears of higher inflation.

Ironically, those fears may have been fanned on Mar. 22 when the Federal Reserve boosted the fed funds rate to 2.75%, a move intended to keep inflation at bay.

The Fed's statement on the day it boosted short-term rates noted that "pressures on inflation have picked up in recent months." Standard & Poor's economists believe that the Fed's comments could signal an accelerated pace of rate increases. Chief economist David Wyss expects a change in the wording of the statement after the May meeting to remove the reference to a "measured" pace of rate rises. Wyss thinks that would allow the Fed to raise short-term rates 50 basis points (half a percentage point) at the June meeting. He believes that the fed funds rate is likely to reach 4% by yearend.

We believe that the Federal Reserve's efforts to contain inflation will be successful this year. Our current estimate is that the year-over-year change in the consumer price index (CPI) for 2005 will be a modest 2.5%, down from last year's 2.7%.

So far, the average annual increase in CPI from 2000 through 2004 has been 2.6%. That compares favorably with the average annual CPI gain of 2.5% in the 1960s. And though the average inflation in that decade was modest, prices did tend to rise faster at the end of the Sixties, long before the 1973 oil embargo.

What ignited inflation in the Sixties? Many experts point to the guns-and-butter policy of large expenditures on both the Vietnam War and the Great Society.

More than a few observers are worried about the current U.S. guns-and-butter policy of spending on anti-terrorism and the Iraq War, while implementing major tax cuts and increased spending on a Medicare prescription drug benefit. Right now, we believe inflation isn't a problem, but it could become one if deficits are not reduced.

Lisanti is editor of Standard & Poor's weekly investing newsletter, The Outlook

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