Inflation and Greenspan haunt financial markets

Dow momentarily dips below 10,000
Market players were in a negative mood all week. Investors worried about the inflation figures -- and were probably right to be concerned after the spurt in the September PPI. Yet, most of the jump was due to special factors. In addition, Greenspan warned investors in a Thursday night speech, that they were not taking risk premiums into account. This caused overnight (foreign) markets to take a dive. Coupled with the PPI figures, it led to a sharp drop in stock prices on Friday. For a short period, the Dow even fell below the 10,000 mark, but managed to close above it. This bearish sentiment won't disappear overnight even with good economic and inflation news.

Bond yields improve on stock plunge, but still higher than last week
Greenspan's speech and the inflation news led to a sharp drop in bond prices early in the day's trading session. Like stock investors, bond market players were focused on inflation news all week. Bond yields drifted higher until they reached 6.35 percent on Friday morning after the PPI news. After the plunge in stock prices, though, bond yields recovered somewhat. Nevertheless, bond yields still posted gains from a week ago. This negative sentiment is sure to continue until the next FOMC meeting on November 16 and the Fed gives a more clear indication where it is headed.

PPI spurts more dramatically than expected
The producer price index jumped 1.1 percent in September -- substantially more than predicted by economists. Even after excluding the regular culprits food and energy, the PPI jumped 0.8 percent for the month. The bulk of the rise was due to a surge in the price of tobacco products, which was expected because of the damage to the crop from the hurricane. Unexpectedly, 1999 model year cars also posted an outsized gain for the month. Excluding these factors, the core PPI would have posted a modest 0.1 percent hike. Indeed, the majority of components are showing relatively stable prices.

The attention on inflationary pressures has market participants looking at all parts of the PPI report. The PPI for intermediate goods edged up a modest 0.3 percent for the month -- and excluding food and energy was up only 0.1 percent. In contrast, the crude materials index jumped 5.1 percent in total, and the nonfood; non-energy component was up 2.2 percent. Crude materials are almost entirely affected by the energy component. On a year over year basis, crude goods prices are up 16.1 percent, although the core is only 1.2 percent higher than a year ago.

As indicated in the chart below, import and export prices are continuing their upward trend. Import prices increased 0.7 percent in September after larger gains in the previous two months. Petroleum import prices jumped 7.2 percent, a moderation from the two previous months! Non-oil prices though are relatively stable -- and in fact are down 0.5 percent from a year ago.

The bottom-line on inflation? There is no question that the best inflation news is behind us. Market players and the Fed need to determine, rather, whether the modest gains of the past few months will continue, or will we see a rapid acceleration? Export prices are running on par with year ago levels. Import prices are only higher than a year ago because of the spurt in inflation. Yet, with economic growth improving in Europe and Asia, market participants and the Fed suspect that the downward pressures coming from foreign competition in the past few years won't continue. As a result, domestic producers may not have the same inclination to hold the lid on prices. The debate seemingly centers on the view that technology and productivity gains will control price increases going forward. It's true that the September PPI figures were frightening, but special factors have a way of disappearing and often reversing. While this data could force the Fed's hand into raising rates at the November 16 FOMC meeting, it doesn't necessarily set the stage for an accelerated pace of Fed tightening moves.

Industrial production still soggy
The index of industrial production fell 0.3 percent in September, nearly reversing the previous month's gain. Among major product groups, declines were recorded in all categories but materials. Among major industry groups, manufacturing production edged down modestly whereas utilities dropped sharply. The plunge in utilities was related to Hurricane Floyd. Indeed, the Federal Reserve Board, which compiles the production data, estimated that production would have posted a minor gain if it weren't for the hurricane.

The bottom-line on production? Industrial production was weaker earlier this year and started to pick up steam just a few months ago. Several of the surveys such as the NAPM as well as factory orders have pointed to a broader recovery in domestic production. Yet, industrial production continues to run at only a moderate pace on a year over year basis. The Federal Reserve is concerned that rapid economic growth will create such tight labor markets that wage and price inflation would be a foregone conclusion. In reality, the gains in production have been anemic and factory employment has posted continuous declines.

Retail sales robust
Retail sales edged up 0.1 percent in September after upward revisions to the previous month. Auto sales fell in September after healthy gains in both July and August. Excluding the auto group, retail sales rose 0.6 percent for the month. The chart below shows that total retail sales were 10.5 percent higher than last September and have pulled away from the non-auto portion have moving in tandem for the past two years. Non-auto retail sales are 8.8 percent higher than a year ago, still a robust gain.

Among durable goods, only furniture store sales rose in September. Nonetheless, increases are much higher among this group than nondurable goods stores which rose 0.8 percent for the month. About half of that rise came from higher prices at the gas pump. Sales gains were more moderate after taking the higher prices into account, but still strong enough to be a concern for Fed officials.

The bottom line on retail sales? The consumer spending spree is not over. Motor vehicle sales may have moderated in September, but consumer spending continues at a rapid clip. Fed officials are just as concerned about the rate of economic growth as the potential for inflationary pressures.

THE BOTTOM LINE
Negative sentiment pervaded the financial markets this past week as investors worry about inflation pressures. The PPI news was ugly at first glance, although beneath the surface, inflation didn't look so worrisome.

Consumer spending continues to grow at a fast clip, although industrial production remains on the soggy side. In any case, September data is not as easy to interpret given that Hurricane Floyd surely affected the data.

It really is too soon to determine whether the Fed will raise rates at the next FOMC meeting. This week's news makes a better case for Fed tightening. Now market players are debating not just whether the Fed will raise rates at the November meeting, but if they will raise rates early in 2000 as well. Stay tuned!

Looking Ahead: Week of October 18 to 22
We use the Market News Service survey of forecasts to describe the market consensus.

Tuesday
Market participants are looking for the consumer price index to increase 0.4 percent in September after more moderate gains in previous months. Some of this expected gain is due to higher energy prices. Excluding food and energy, the CPI should post a 0.3 percent hike due in part to higher tobacco prices. But the tobacco component is not as large as in the PPI and should have a smaller impact. The core CPI rose 0.1 percent in August.

Housing starts are expected to drop 2.5 percent in September to a 1.63 million unit rate. At the same time, permits are expected to remain roughly unchanged at a 1.62 million unit rate. The weekly MBA purchase applications index has been trending lower for the past couple of months and tends to lead housing starts for three to four months.

Wednesday
The consensus forecast is showing the international trade deficit to remain about unchanged in August at $25 billion given the previous record shortfall of $25.2 billion. While the upward trend in exports is expected to continue from improved foreign economic growth, U.S. consumers and businesses continue to buy imported goods at a rapid clip.

Thursday
Market participants are expecting new jobless claims to increase 5,000 in the week ended October 16 from last week's 285,000.

Economists are predicting that the Philadelphia Fed Survey will decrease marginally in October to 15.0 after a rise in September. On the whole, this reflects solid manufacturing activity in this region.