The accumulating signs of an economic slowdown in recent weeks have, in the eyes of many, confirmed the Federal Reserve’s bias for pausing with interest-rate hikes. If economic growth is fated to become tepid, goes the reasoning, it will take the edge off inflation’s momentum.
The conceit buried in this school of thought is that the supply of money carries marginal sway on inflation’s course. That’s a disturbing view for monetarists, who hold that inflation is a phenomenon driven by changes in the money stock relative to the economy.
Among the main lessons embedded in this belief is that inflation and rapid and/or dramatic price increases aren’t necessarily one and the same. A shift in supply and demand moves prices. This has nothing to do with inflation, counsel the monetarists. Rather, an uninformed rise in the stock of money (i.e., a rise that’s more than the general economic conditions require for maintaining an orderly functioning of the economy) is one that ultimately elevates prices, but for reasons that are detached from supply and demand trends.
A new paper that preaches the value of seeing inflation as a monetary phenomenon comes from Edward Nelson of the St. Louis Federal Reserve. The research (The Great Inflation and Early Disinflation in Japan and Germany) documents that Japan and Germany in the 1970s witnessed an inflation that peaked relatively early and generally stayed lower compared with other nations in the West, notably the United States. He concludes that the “German and Japanese experiences in the 1970s indicate that once inflation is accepted by policymakers as a monetary phenomenon, the main obstacle to price stability has been overcome.”
The topic of debate before the house today is whether the “main obstacle” to price stability has been conquered in the collective mind of the Fed’s leadership. The current head of America’s central bank, to cite one example, has gone on record explaining that as the economy slows, so will inflation. Backing up that outlook with action, the Fed on August 8 put rate hikes on hold, an act that’s widely expected to have a repeat performance on Wednesday, when the FOMC meets again to consider the proper state of money’s price.
In fact, there are instances in history when an economic slowdown didn’t deliver a commensurate drop in inflation, the 1970s being the egregious example. America, in particular, suffered from so-called stagflation during that decade. Nelson finds that Germany and Japan suffered less. The reason is mostly due to decisions about money supply in those countries, he counsels.
That brings us to the observation that the rate of money supply is again heading up in the United States. The M2 measure of the nation’s money stock advanced by 4.9% over the past year through September 4–the highest since mid-July, according to Fed data. This is what one might expect when interest rates stop rising. Deciding if it’s also the right policy at the right time, assuming it continues, is another matter.

Of course, confirmation or rejection of the Fed’s current policy will come only after months and years, as opposed to the days and weeks that investors seem to think is the appropriate period for analysis. For that reason, we remain hopeful that the central bank will do the right thing in time, and that the recent trend in M2 isn’t necessarily indicative of things to come in the long run. What’s more, if inflation does in fact continue trending down, the risks of M2 growing lessen.
In the meantime, there is history to consider, including a variety of outcomes that central banks have dispensed over time by way of a variety of strategies. Some in the central banking system are studying that history. Only time will tell if those in the upper echelons are also availing themselves of the opportunity.

This morning’s report on consumer prices for August is the gift that the markets have been looking for.
Inflationary pressures eased last month, the Bureau of Labor Statistics reported, with the CPI advancing at just 0.2% in August, down by half from July’s 0.4%. The core rate of inflation, meanwhile, held steady: CPI less food and energy rose 0.2% last month, as it did in July.
The big contributors to the slowing of pricing pressures were energy and transportation. Energy prices gained by a mere 0.3% in August, a universe below July’s 2.9% surge. The pace of transportation-related price hikes also took a healthy dive, registering a 0.2% rise, down sharply from the previous month’s 1.6% climb.

August, in short, took a fair chunk of the momentum out of inflation’s sails. The core rate of CPI is now running at an annual 2.8%. That’s still a bit on the high side as far as the Fed’s upper range of tolerance is concerned. Bringing core CPI down to the low 2% range is the immediate goal, and a prudent one if the central bank is still concerned (as it should be) with managing inflation as a long-term proposition. As such, the Fed will have to remain vigilant. But for the moment, there’s no immediate sign that inflationary pressures are accelerating. Confirmation that the trend is more than a blip will only come in future months, but hope has suddenly taken a big step up in valuation.
Indeed, with oil prices down around 10% so far this month, a repeat performance of easing consumer prices looks on track for the September CPI report. Next Wednesday’s FOMC meeting at the Fed, in short, will have fresh data to lean on for rationalizing keeping interest rates on pause.
Mr. Market has been anticipating no less. The S&P 500 has been climbing steadily if slowly since mid-July, and on Wednesday touched its highest level since May. The bulls have been in charge in the bond market too, pushing the yield on the 10-year Treasury Note down under 4.8% for much of this month–the lowest since March.
Year to date through last night’s close, the total return is 6.9% for the S&P 500, and 2.2% for the widely watched Lehman Brothers Aggregate Bond Index. The upward momentum in equities is also evident elsewhere on the planet. MSCI EAFE, in dollar terms, is up more than 13% so far this year, and MSCI Emerging Markets (also in dollars) has climbed nearly 8.9% in 2006 through yesterday.
With so much having gone wrong in the recent past, the markets are inclined to celebrate now that a number of things seem to be going right. For the moment, the bulls can breathe a sigh of relief.
Having anticipated the current good news, where do the markets go from here? More of the same? The markets, after all, are about valuing the future, not the past.
But let’s not spoil today’s party with awkward questions. Let’s save such inquiries for next week. Meanwhile, enjoy the show.

Two data points are a drop in the economy. But the two that rolled off the wires this morning caught our attention just the same. Such is life in these data-dependent times, when every scrap of new information is inhaled in search of clues about tomorrow. In that state of mind, we found reason to do a double take at the sight of retail sales posting dramatically slower growth while import prices continue to reach upward. Was this something to worry about? Or should we simply chill and switch to decaf?
U.S. retail and food services sales for August grew by just 0.2%, the Census Bureau reported. After July’s 1.4% surge over June, 0.2% looks a tad thin. Meanwhile, the Labor Department advised that import prices jumped 0.8% last month and the original estimate for July was revised up to 1.0% from a mere 0.1%. The combination of slowing consumer spending and rising prices by way of the nation’s voracious appetite for imported goods is something less than ideal at this moment in the economic cycle. Gee, what will Bernanke think?
Of course, one could opt to emphasize the positive, such as it is. Let’s give it a whirl, shall we? Let’s start by noting that the 0.2% rise in retail sales is an improvement over the consensus outlook that called for a slight decline of -0.2%. In addition, retail sales look more robust by comparing August’s tally to its year-earlier total. By that measure, retail sales jumped 6.7% on the year, or more than twice as high as the economy’s pace of growth in the second quarter. Not too shabby for a consumer population that’s thought to be laden with debt.
David Resler, chief economist at Nomura Securities in New York, finds reason to see the glass half full rather half empty on the retail front. The “underlying retail trend has picked up a bit after a sluggish second quarter and seems to be growing at a pace that is consistent with trend-like growth in overall consumer spending,” he wrote in a note to clients this morning.
Over on the imports ledger, prices are advancing at a far slower pace once you remove energy from the calculation. While import prices overall rose 0.8% last month, the climb was a lesser 0.5% for non-petroleum imports. The year-over-year record is also slower once you take out energy: 2.7% vs. 6.6%. In addition, the 12-month rate of change for top-line import prices slowed again last month, as it has in the two previous months. The trend, at least, is encouraging. Meanwhile, the fact that oil prices have been dropping of late adds to the hope that the import prices will be revised down.
Mr. Market, in fact, continues to emphasize the positive. The initial reaction among traders in Fed funds futures to the news this morning on retail sales and import prices tells the story: the October contract is virtually unchanged, priced in anticipation for more inertia at next week’s FOMC meeting, i.e., keeping Fed funds at 5.25%.
Steady as she goes, an optimist might say. One more hurdle before the weekend. Let’s see how cheerful we are after reading tomorrow’s report on August consumer prices. Meanwhile, optimism springs eternal…at least through the end of trading today.

A new research paper that analyzes the timing of stock market booms around the world in the 20th century in relation to macroeconomic conditions probably won’t surprise enlightened observers of the money game. But what the paper lacks in shocking disclosures it makes up with a timely reminder that equity bull markets tend to thrive under a particular set of conditions. Conditions, some argue, that appear to be on the wane these days.
Indeed, a new working paper published on the St. Louis Fed’s web site, When Do Stock Market Booms Occur? The Macroeconomic and Policy Environments of 20th Century Booms delivers fresh reason to wonder if the current run in stocks still has legs. “We find that booms generally occurred during periods of above-average economic growth and below-average inflation, and that booms typically ended when monetary policy tightened in response to rising inflation,” write authors Michael Bordo (an economics professor at Rutgers) and David Wheelock (an economist at the St. Louis Fed). “Most booms were procyclical, arising during business cycle recoveries and expansions, and ending when rising inflation and tighter monetary policy were followed by declining economic activity.”
How does that trend relate to the outlook for stocks in 2006? Or, perhaps we should ask, does it relate at all? Before we can even take a shot at an answer, there’s the awkward problem of deciding if the economy is currently winding down, heading up or set for an extended period of treading water. Alas, the jury is out on this one–way, way out, to judge by the degree of uncertainty that permeates the economic news of late.
To be sure, a considerable downshift in economic growth has been recorded in the second quarter relative to the first. Meanwhile, there’s any number of reasons to think that the slowdown is more than temporary, including the widely publicized slippage in the housing market. But the optimists aren’t giving up just yet.
The latest catalyst for thinking that the old bull isn’t dead yet comes by watching the decline in oil prices. A barrel of crude is priced under $64 in New York trading, the lowest since March, and down by more than $10 since early August. Hardly a bargain by the standards of the past decade, but the direction at least is expected to cheer the consuming masses.
Today’s Wall Street Journal ran a story that explores the potential for a fresh burst of consumer spending fueled by the recent drop in energy prices. Although some dismiss the idea outright, others still find reason to think that a second wind is possible in the current cycle. Robert Mellman, senior economist at J.P. Morgan Chase, is one dismal scientist who thinks that Joe Sixpack may find inspiration anew for pulling out his credit card down at the local mall. Lower gasoline prices could raise the annual pace of consumer spending a full percentage point, he told the Journal. In turn, the annualized fourth-quarter economic growth would jump to 3.7% from an expected 3.0%.
Of course, oil and gasoline prices need to stay down for more than a few weeks to deliver tangible results. We’ll see.
Meanwhile, Bordo and Wheelock’s research raises some provocative questions at a time when inflation, while still relatively low, has ticked up. Stock market booms, the authors write, “typically arose when inflation was low and declining, and ended within a few months of an increase in the rate of inflation. Rising inflation tended to bring tighter monetary conditions, reflected in higher real interest rates, declining term spreads, and reduced money stock growth.”
Among the many questions weighing on Mr. Market comes one more that’s inspired from Bordo and Wheelock’s research, namely: Does the paper’s observation of the past inform investors about what comes next?

There are many things to fear when looking at the economy and its capacity for surprising, and wages taking wing may be one of them. Of course, if you’re a long-suffering worker, the trend is worthy of celebration. But expecting the pace of labor income to keep running higher is something to lose sleep over if you’re a central banker (or an investor betting that rates will stay flat or fall).
Indeed, the subject or wages promises to be the new new thing as 2006 goes into its final stretch. To be precise, how much of the bubbly wage growth of late will be inflationary? Or, to summarize the optimists, will the upward trend in wage growth be offset by productivity gains and weakness elsewhere in the economy, notably in real estate? Such are the questions that keep investors wondering and economists working.
Analysts Charles Dumas and Gabriel Stein of Lombard Street Research in London believe that the folks at the Fed may lose a little shut-eye in the foreseeable future. Stein wrote yesterday in a note to clients that “labor income growth is accelerating” in the U.S. His colleague, meanwhile, observed last week that “huge” revisions on wage growth estimates point to more Fed tightening.
Not everyone agrees, of course, and we’ll get to that shortly. But first, a closer look at Lombard’s analysis, starting with Stein. The U.S. economy is entering what he calls an anti-Goldilocks phase, which he defined as “both too hot and too cold at the same time….” Too hot, he continued, “in the sense that household incomes clearly remain strong and are likely to keep powering the economy for some quarters further. In fact,

with non-farm labor income rising by 6%, household spending by itself should be enough to propel the economy to close to trend rate growth–always assuming, of course, that the savings rate does not suddenly begin to rise.”