The Truth About Inflation

Yes, wholesale inflation experienced its biggest surge since 1974. But on close inspection, price increases aren't accelerating

The government's Dec. 19 report on wholesale inflation made for a heck of a scary headline. The producer price index rose 2.0% in November, the biggest jump since 1974. Shades of Richard Nixon! Trouble ahead for Federal Reserve Chairman Ben Bernanke! For a few moments after the 8:30 a.m. news release from the Labor Dept., bond traders acted as if someone had released scorpions on their trading desks.

But after a few minutes of chaos, it became clear that inflation was not rearing its ugly head after all. Strip away a few components whose prices seesaw drastically from month to month, and the index rose just 0.2%, which is far from alarming.

Limited to a Few Sectors

In fact, the bad news on prices was concentrated in a handful of sectors. Gasoline prices, which had been falling, rose just under 18%. Car prices increased 2.2% after dropping 2.3% in October. And light trucks—including SUVs—rose a record 13.7% in November, reversing what had been a record decline of 9.7% in October. Civilian aircraft prices rose 1.1%. "Outside of transportation equipment, there was practically no producer pricing power in November," wrote David Rosenberg, chief North American economist for Merrill Lynch (MER).

So, it was a case of reverse gravity: What goes down, must come up.

The report didn't even cause Action Economics, a leading forecasting firm, to up its estimate for another widely watched measure of inflation, the price index for personal consumption expenditures. Action Economics is expecting the overall price index to rise just 0.1% in November, and the core index, which excludes food and energy, to be unchanged. (Unchanged meaning, of course, zero inflation. That doesn't sound much like the dark days of 1974.)

The headline did look bad at first. When news services reported the 2.0% jump at 8:30 a.m., bond traders went into sell-first-ask-questions-later mode. After all, high inflation erodes the value of fixed-income securities like bonds. The yield on the 10-year Treasury note (which rises when prices fall) shot up almost instantly from 4.57% to 4.62%. But as more information emerged, prices recovered and yields settled back down to around 4.59%, which is about where they had been the day before.

Homebuilding Still in Slump

Producer prices weren't the only numbers making inflation watchers nervous on Dec. 19. The Census Bureau reported that housing starts rose 6.7% in November, creating the impression that the home construction slump was ending (see, 12/19/06, "Housing Starts Perk Up in November"). While a rebound would be good for employment, it would be bad for inflation because it could force up wages and materials costs. But there again, for inflation watchers, the headline was worse than the reality. A big reason for the rise in November was that the weather improved from October, when housing starts were at their lowest level in six years.

Evidence that the homebuilding slump has further to go: Permits fell in November to their lowest since 1997. Permits are now down 31% from a year ago—the kind of decline that in the past has signaled a recession or at least extremely slow growth, says Merrill's Rosenberg. In addition, homebuilder Hovnanian Enterprises reported a sharply larger than expected loss, due to the write-off of land options and inventory impairments. That drove down the stock of Hovnanian (HOV), as well as those of DR Horton (DHI), KB Home (KBH), and Centex (CTX) (see, 12/19/06, "Homebuilders Take Another Hit").

So, what's the greater risk to the economy: inflation or recession? The Federal Reserve, under Bernanke, made it clear last week that it sees inflation as the bigger threat. And on Dec. 19, Federal Reserve Bank of Dallas President Richard Fisher amplified on that, saying, "The risk of unacceptably high inflation still outweighs the risk of substandard economic growth," according to his prepared remarks. Fisher said inflation is too high and the Fed would "have no choice but to advocate tightening monetary policy further if inflation does not ratchet downward."

Recession a CFO Concern

Fisher and his Fed colleagues are more worried about inflation than your average chief financial officer. According to a survey released Dec. 19 by Financial Executives International and Baruch College's Zicklin School of Business, 30% of participating CFOs were quite concerned to very concerned about recession, compared to 16% who are quite concerned to very concerned about inflation.

Aside from brief inflation scares like the one on Dec. 19, the financial markets seem more in the camp of the CFOs than that of the Fed. So are many economists, who think the Fed is going to ease rates downward over the coming year to stimulate growth. The average forecast for the federal funds rate in the fourth quarter of 2007, based on BusinessWeek's survey of 58 professional forecasters, is 4.9%, vs. 5.25% now. Of course, forecasts can be far from reality. And Bernanke and his colleagues at the Fed will have the final call.

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