Core CPI may be under control, but the Federal Reserve isn’t convinced that the war on inflation is over just yet.
The central bank’s “predominant policy concern remains the risk that inflation will fail to moderate as expected,” today’s FOMC statement advised. That’s a verbatim repeat of what the Fed said after the last FOMC meeting in May. But this time it added a proviso: “Readings on core inflation have improved modestly in recent months. However, a sustained moderation in inflation pressures has yet to be convincingly demonstrated. Moreover, the high level of resource utilization has the potential to sustain those pressures.”
The warning is all the more striking coming just 13 days after the encouraging report on May’s reading of core inflation, the Fed’s preferred prism for viewing monetary-policy-relevant pricing trends. More than a few analysts reasoned that after that heartening report on core, the central bank was home free. But now we’re told that any cheering was premature.
“The Fed is signaling it wants it proven first that inflation is down and will stay down,” Gerald Lucas, senior investment strategist in New York at Deutsche Bank, told Bloomberg News after the FOMC release.

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The government updates the first-quarter GDP tomorrow, but till then we’re told that the economy expanded by a scant 0.6% in the first three months of this year, based on a real, annualized calculation. Meanwhile, the real yield on the 10-year TIPS closed yesterday at 2.70%, which is to say that inflation-indexed Treasuries offer a considerable yield premium over the pace of economic expansion.
By that standard, U.S. interest rates are tight by more than a little relative to recent economic growth. Of course, the relationship between the price of money and GDP’s pace evolves, sometimes dramatically. GDP rose by a strong 5.6% in real, annualized terms in Q1 2006, a quarter that witnessed real yields on the 10-year TIPS in the low-2% range. In other words, the price of money in early 2006 appeared loose, but has since given way to looking tight.
The challenge to that theory comes by surveying the price of money internationally. BCA Research yesterday published a provocative chart showing that globally defined bond yields generally are low relative to the world economy’s rate of growth. Interest rates, the research shop opined, “are not yet restrictive.” From that analysis comes the counsel that global equities looked poised to rise. “It will take a much sharper rise in the cost of debt to curtail the bull market in global equities. Until then, our outlook for higher stock prices remains intact,” BCA counseled.
So far, so good. But the human mind is subject to what’s only just passed, and on that score there’s the issue of red ink to assess. A look at MSCI’s suite of benchmarks for various slices of developed foreign markets shows a trend of unmistakable consistency: down. For the past month, virtually all MSCI indices in the developed world are in varying states of loss. Representative of the trend is MSCI EAFE, which is off by 1% for the past month, in dollar terms.
But even here, selectivity in how one reviews the world’s equity markets offers alternative results. Emerging markets continue to bubble. MSCI Emerging Markets is up 3.6% for the past month, in dollar terms. Regions within EM are doing even better over the same period, with MSCI EM Asia rising 5.6% for the past month and MSCI EM Eastern Europe adding 7.2%.

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The Federal Reserve’s FOMC meets again this week to decide what’s next for the price of money. Judging by Fed funds futures, more of the same is what’s next, which is to say more of letting it ride.
The July contract is priced in anticipation that Fed funds will stay at the current 5.25%. Looking at longer-dated contracts doesn’t materially change the outlook. But no matter what the central bank decides on Thursday when it makes a formal announcement of its monetary policy, someone will be grumbling.
Ours is a moment of anxious bulls and confident bears. There’s plenty to worry about, and yet encouraging news can still be found with minimal effort. As such, the casual observer of the American economic scene can be forgiven for feeling confused. On the one hand he’s reading stories laced with references to hedge fund woes and subprime mortgages, real estate corrections, higher interest rates and warnings by some that the economy is headed for rougher waters. Adding to the worries is yet another rise in oil and gas prices, which is an equal-opportunity offender in reducing that all-important variable for economic momentum: disposable personal income.
At the same time, unemployment is a relatively slim 4.5% and weekly jobless claims, while not exactly low, have for some time remained in a holding pattern that can optimistically be called slightly elevated. Meanwhile, last month’s report on retail sales suggests there’s still plenty of get-up-and-go in the consumer sector.
“Seventy percent of Americans now say the economy is getting worse,” observed Donald Lambro, a columnist at the conservative-minded Townhall.com. But he added that the sour outlook is “contradicted by a growing workforce, increased wages and household wealth, and a stock-market rally that has boosted worker-retirement investments.”

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The debate over inflation’s future path is for many a question of focus. For those who look to top-line inflation, as measured by the consumer price index or its cousin, the personal consumption expenditures index, the trend is clear: prices are rising.
But the response to the contrary comes by those who say that core measures of CPI and PCE are more relevant. By that standard, the trend of late reflects control and containment.
The disparity between the two measures of inflation is no great mystery. The rising price of energy is captured in top-line CPI and PCE, and this measure of inflation has been climbing. Energy and food are excluded from the core measures, which explain why core CPI and PCE look calm and their top-line counterparts are rising.
But as a recent research note from the St. Louis Fed reminds, the jury is still out on what a widening disparity between top-line and core measures of inflation means for monetary policy. “A disconnect between measures of headline and core inflation could be a concern for policymakers,” Riccardo DiCecio, an economist at the bank advised. “It may not be reasonable to conclude that monetary policy has been effective in maintaining price stability by looking solely at a core measure of inflation that excludes sustained oil price increases.”

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Change may come slowly, almost imperceptibly to the capital markets. Or it may come as a thunderbolt from the blue. But invariably it comes, raising questions and sidetracking long-running expectations in the process.
What’s unfolding presently in one corner of the marketplace appears to be change in its more subtle hue. That leaves room for debate, although it spurs questions too. Reading the trail left by the major asset classes shows that REITs are at the head of the shifting financial winds. Posting the only loss so far this year among our list of broadly defined markets, real estate securities are testing a concept that has long eluded the sector: loss.
As our table below shows, red ink distinguishes the asset class so far this year:

To find a calendar year in which REITs generally suffered a loss one has to return to 1999, when Wilshire REIT’s total return was a negative 2.6%. Since then, REITs have been on a bull market run that’s extraordinary for its duration and magnitude. If you had the prescience to buy the Wilshire REIT at the close of 1999, the resulting annualized total return from that point through this past May was a stellar 22.3% vs. a paltry 2.2% for the S&P 500, according to Morningstar Principia software.
The question is whether the REIT train has finally run its course? No one knows, but there are several reasons to consider the possibility. We can start with the observation that nothing goes up forever. REITs have taken flight now for seven years straight through the end of 2006. We don’t know if fate will make that eight in a row, but after such a long bull run, the odds of extending a rally with ancient origins looks decidedly lower the longer the party goes on.

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Former Fed Chairman Alan Greenspan, speaking last November, predicted that the worst of the housing market’s correction had passed. But judging that commentary by housing starts suggests otherwise.
The government this morning advised that the seasonally adjusted annual rate of housing starts for May dropped 2% from April. Compared to last November, starts are off nearly 6%. Looking at the data on an annual basis reveals that housing starts are almost one-quarter lower compared to a year earlier.
One might point out that the low point for starts arrived this past January, as our chart below shows. But the trend since, although technically improved since that trough, has yet to inspire confidence that a genuine recovery has arrived.

It should also be noted that while housing’s future trend remains a question, the larger economy has yet to suffer an associated shock of any great magnitude. Although no one will confuse June 2007 with June 2006, optimism is still the easier sell. But make no mistake: there’s still reason to worry that housing’s ills aren’t over and that the virus may grow bigger as a negative for the larger economy.

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Mr. Market is full of surprises. Some are good, others less so. For the moment, the fomer seems to be in control when it comes to equities, and arguably the main reason is the fact that consumers continue to surprise as well with a seemingly non-stop bout of spending.
More than a few analysts have been surprised by the trend. Indeed, bears remain flabbergasted that the median firm in the S&P 500 reported a 10.1% rise in earnings in the first quarter, according to Zacks. That marks the 19th consecutive quarter of double-digit gains. Perhaps even more encouraging for the here and now is the fact that two cyclical sectors of the S&P reported the strongest earnings gains in Q1: a 14.5% jump for materials (which was the earnings leader among the 10 sectors); and a 13.5% rise for industrials.
One is inclined to connect the dots and note that Joe Sixpack’s affinity for spending shows no sign of slowing in recent history. The latest evidence came in last week’s retail sales report for May, which registered a 1.4% jump over the previous month–the strongest monthly advance since January 2006. Reports of the death of consumer spending, in other words, have been greatly exaggerated.
The future, of course, is up for grabs, as always. But for now, there’s no denying the basic American urge to spend, to keep on spending, and spend a little more. If Joe wills it, channeling triumph by way of his wallet, a financial reckoning of any great magnitude will be postponed. No one can say for how long, but skeptics of the Joe’s capacity for consumption, conspicuous or otherwise, have taken it on the chin so far.

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Thank goodness for core!
For those intent on staying positive on the future path of inflation, focusing like a laser beam on the so-called core rate of the consumer price index is essential to one’s mental health.
This morning’s report on CPI offers a potent example. On the surface, there’s bad news: top-line CPI rose 0.7% last month, the highest since September 2005’s anomalous 1.2% surge. As a result, CPI’s annual pace as of May is a worrisome 2.7%. More troubling than the absolute level is the trend. Since late last year, CPI’s annual rate of change has been climbing. As recently as last October, annual CPI was a mere 1.3%–lower by more than half compared with the current inflation.
But optimism has a savior in the core CPI reading, which extracts the troublesome energy and food prices from the mix. By that standard, all’s well. In a bubble universe where no one buys energy and food, inflation is barely worth a mention. The 0.1% rise in core CPI last month was lower than April’s 0.2%. In fact, the annual change in core CPI through May is notable mainly for its descent over time. For the fourth month running, the 12-month change in core CPI has fallen, posting just 2.3% for May, down from 2.9% in September 2006.
The question then becomes: which one speaks the truth? The answer depends on one’s perspective. Indeed, the central bank has a fondness for the core reading because it conveniently strips out the biggest pricing variable over which the Fed has no control: energy. True, of course, and so there’s a case to be made for central banks focusing on core. The hope, and it’s not entirely unjustified, is that the Fed can excute a prudent monetary policy by ignoring food and energy prices. If so, the benefits will eventually flow to the economy overall. By that standard, we can all rest easy.

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Yesterday’s news on the strong jump in retail sales cheered equity investors. And for good reason: the 1.4% gain in consumer spending in May is the highest in 16 months. But in keeping with the spirit of the times, for every bit of good news, there lurks a new reason to worry.
Yesterday’s news on import prices, for instance, surprised on the upside, coming in at 0.9% last month, which was much higher than the consensus forecast.
Meanwhile, this morning’s producer price report for May offers another indication that pricing pressure may be staging a comeback in the wholesale world. Seasonally adjusted PPI advanced by 0.9% last month, up from 0.7% in April. On an annual basis, PPI rose by 3.9%. As our chart below shows, it’s clear that there’s inflationary pressures, while not necessarily fatal, remain a concern.

The optimistic view is that after stripping out food and energy, PPI still looks tame. Yes and no. It’s true that core PPI rose just 1.6% for the 12 months through May–less than half the pace for the top-line number. But the annual rate of 1.6% is unchanged from April. In fact, the annual rate of change in core PPI has been holding fairly steady in a range of 1.6% to 1.8% this year. The question: will the core rate be pulled up if the top-line pace continues to take flight? Looking beyond PPI one may wonder what’s in store for consumer prices, which have been showing signs of trending higher too. Tune in tomorrow for the May CPI report.

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The rise in the 10-year Treasury yield to its highest level since 2002 may or may not signal a secular change in the future supply of liquidity. But when it comes to interpreting the signal, strategic-minded investors should think strongly about erring on the side of caution. The advice is all the more relevant for those who’ve profited from the liquidity driven bull market of the past five years that’s dispensed gains in all the major asset classes.
For all we know, the current spike in interest rates may end tomorrow–or not. But when the bond market sends a message this crisp, we’re reluctant to dismiss it out of hand.
Then again, the rise in the 10-year yield isn’t all that astonishing, given the recent evidence that the economy’s still bubbling. For those who assume the economy’s not headed for recession any time soon, the case for an inverted yield curve (long rates below short rates) has been on shaky ground.
“We’ve been through a three- or four-year period where yield curves have been a weird shape,” said Tim Bond, head of asset allocation at Barclays Capital, told Reuters. “I think you’ve got further to go [with rising interest rates]; yield curves are just normalizing.”
No matter your view on where the economy’s going, the bond market has some very definite ideas. To be sure, the ideas of the moment stand in sharp contrast to the ideas of the recent past, as our chart below reminds. In fact, those ideas may change again.

The future, of course, is debatable; the past is set in stone. Looking at the carvings left by fixed-income trading reveals that something approaching a normal state may be coming in the relationship between yields and maturities. Using last night’s close as a guide, there now exists a 60-basis point spread in favor of the 10-year over the 1-month T-bill. At the close of last year, the 10-year’s yield was 10 basis points under the 1-month T-bill. On its face, the change implies that the economy will stay stronger than previously assumed. Now all we need is fresh data to support the bond market’s forecast.

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