May 17, 2006
TRANSITION TIME--THE WEDNESDAY INSTALLMENT
Inflation may not be an overt threat at the moment, but it's too early to stop worrying.
Today's release of the consumer price index for April reminds that the pendulum is precariously balanced and may swing one way or the other in the months ahead. Correctly deciding which way it swings has become the all-important variable that will determine profit and loss for the foreseeable future among the more speculatively inclined players in the capital markets.
CPI's 0.6% rise last month isn't the highest we've seen in recent years, but neither is it the lowest. In fact, April's advance, when put in context with recent history, exhibits many of the qualities that one associates with persistence. Stubborn upward persistence, we might add, noting that prices seem inclined to rise rather than play dead.
The trend is obvious when one looks at a chart of monthly 12-month CPI percentage change over time. Indeed, consumer prices are pushing higher over time. The trend unfolds in fits and starts, but it's a trend nonetheless.
Even the so-called core rate of CPI, which excludes food and energy, appears to be percolating higher. For the second straight month through April, core CPI is running at 0.3% a month, a clear step up from recent history. This is especially worrisome since the formerly quiescent core CPI has been the fountain of optimism from which inflation doves have been drinking. If this gives way, a broader rethinking of inflation expectations may be coming.
If so, the Federal Reserve will have no choice but to continue nipping pricing pressure in the bud, an effort that of course means interest rates will rise further. The bond market seems to understand the risk at the moment, even if it proves to be hollow down the road. There are no shortage of pundits advising that the economy will slow in the coming months and in 2007, in which case inflation's upward momentum may prove to be short lived.
But today, the fixed-income set is reading the trend lines on the wall at the moment and deciding that caution trumps heroism in the bond pits. As we write this morning, the 10-year Treasury yield is 5.16%, which is to say it's bumping up against its highest level in four years. Meanwhile, over in Fed funds futures trading, there's a growing suspicion that more rate hikes are coming as the year unfolds.
The celebrations of the recent past, born of the belief that the Fed would pause with rate hikes, are giving way to the sober reality imposed by the data. Indeed, the Fed has counseled the markets to price securities to do no less, having advised in its May 10 FOMC statement that "further policy firming may yet be needed" depending "on the evolution of the economic outlook."
The economic outlook is in fact evolving, and perhaps faster than some expected. Or so today's higher-than-expected April CPI implies. "The risks of a June Fed hike are higher, although we still have to see May's CPI and plenty of activity data between now and the next Federal Open Market Committee meeting," David Sloan, an economist at 4CAST Ltd., opines in an interview with Reuters today.
It's all about the data now.
Posted by jp at May 17, 2006 10:27 AM
Makes you wonder what would have happened if the Fed had invoked a little more common sense, and turned a few of those 25 basis points hikes into 50 basis points hikes a year or two ago, when the possibility for inflation was becoming much clearer.
It didn't take a rocket scientist to realize that the excess liquidity injected would need to be taken out at some point - and moving those rates up a little faster back then, wouldn't have been imprudent.
Even now, they should consider this possibility - although the risks are now higher.
The Confused Capitalist
Posted by: Jay Walker at May 17, 2006 3:10 PM