Can the Fed Corral Inflation?

S&P Economics does not currently call for a dramatic increase in inflation

Last week, the equity markets dodged a bullet when the S&P 500 recovered on March 18 from the Bear Stearns’ induced sell-off of March 17.

JPMorgan Chase agreed to acquire Bear Stearns for just $2 a share, or $236 million. Following an early plunge in the market, the S&P 500 rallied by the end of March 17 to remain above the 1270 level, what we believe to be critical support.

Even though S&P equity analysts have a negative fundamental outlook on the investment banking & brokerage industry and have two-STARS recommendations on most industry constituents, investors likely looked upon the pending sale of Bear Stearns as one issue they can stop worrying about. It probably didn’t hurt that the Federal Reserve backed the JPMorgan (JPM)-Bear Stearns (BSC) merger with $30 billion, and then lowered the Fed funds rate by 75 basis points at the March 18 FOMC meeting.

The Fed explained that the easing in the funds target to 2.25% was due to further weakness in economic activity and the flux in the financial markets. The FOMC acknowledged a rise in inflation, but said it continues to expect inflation to moderate in the coming quarters. The committee indicated that further rate cuts could be seen, since “downside risks to growth remain.” S&P Senior Economist Beth Ann Bovino said a cut to 2% is likely.

"While recession is the imminent threat, the Fed remains concerned about inflation," Bovino says. "Most Fed members feel that the Fed has to fight recession now, and worry about inflation later."

Bovino noted that Fed Chairman Ben Bernanke not only has the deterioration in the U.S. economy on his mind, he is worried that the steep rally in oil prices is primarily responsible for the increase in consumer price inflation.

"Overall, ongoing strength in headline inflation and the continued upward drift in core rates should keep the FOMC concerned about longer-term inflation risk, even if all of the short-term focus remains on recession risk," she says.

S&P Economics expects headline and core consumer prices to decelerate over the next two quarters. This implies a deceleration in unit labor costs to 2.1% in 2008 from 3.1% the year before, and a drop in oil prices from the record high of $111.80 a barrel reached on March 17 to an average of $91.33 by year-end, and Bovino acknowledges the risks to these forecasts. If oil continues to rise, the value of the dollar depreciates more than expected, and productivity slows sharply, inflation would rise rather than moderate, she says.

Inflation fears were stoked on March 18 after a greater-than-expected increase in the producer price index (PPI) core rate was reported.

Bovino noted that import prices rose 0.2% in February, as a 1.5% drop in energy prices was offset by a 0.6% jump in other prices. Non-petroleum import prices rose 4.5% from a year ago, clear signs of inflationary pressure from the weaker dollar.

However, if the Fed proves correct in its assessment of moderating inflation, and taking into account the recent decade’s data, investor concerns should be mitigated.

S&P economists aren’t predicting a significant rise in inflation. While their forecast is for the consumer price index (CPI) to rise to 3.5% in 2008, up from the average 2.9% in 2007, they expect it to decline to an average of 2.1% in 2009. They also see the core CPI averaging around 2.6% through 2011, since they expect a global economic slowdown in 2008 to lead to reduced demand, continued pressure from global competition, and the expected decline in oil prices to match fundamental expectations. S&P forecasts West Texas Intermediate crude to decline to $89.93 a barrel in 2009.

From January 2000 through February 2008, the headline CPI (which includes the effects of food and energy) increased, on average, 2.8% per year. Yet that’s nothing when compared with the 7.1% average for the 1970s or the 5.7% in the 1940s.

Of course the reasons for the hefty increases in those decades — high oil prices and expensive military engagements, such as World War II and Vietnam — are very much in evidence today. We also have high oil prices and mounting debts from our military involvements in Afghanistan and Iraq.

Historically, the S&P 500 posted its strongest monthly advances during periods of modest increases in inflation (2.0%-3.9%), yet stocks came under pressure when the headline CPI’s rate of annual change rose above 4.0%. We believe, therefore, that the market may welcome a touch of inflation — but not too much — since slightly rising inflation implies that the economy is growing and producers are able to boost earnings through price increases.

During periods of accelerating inflation, investors traditionally gravitated toward the "real asset" areas of energy (XLE) and materials (XLB), as well as the more defensive sectors of health care (XLV) and utilities (XLU). S&P equity analysts have five-STARS recommendations on 90 stocks; 29 of these issues come from the energy, health care, materials, and utilities sectors.

Within these four areas, the single-sector representatives with the highest difference between the current and target prices are: Superior Energy Services (SPN; recent price, $36; S&P target, $57), GTX (GTXI; $14; $27), Airgas (ARG; $45; $55), and Huaneng Power (HNP; $26; $44).

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