CPI Hammers Stocks Econoday Simply Economics 4/17/00 By Evelina M. Tainer, Chief Economist

The gap is gone
Stock prices plunged on news that inflation was worse than expected in March. This led to fears that the Fed may become more aggressive in their future rate hikes. The initial drop sparked margin calls leading to more price declines, according to dealers and analysts. Some also said investors were selling stocks in order to pay tax bills for large 1999 capital gains.

For months, market analysts have worried about the wide gap between the increases in the NASDAQ composite index and the sluggish behavior of the old blue chip sector. The Dow Jones Industrials never managed to regain its early January levels – that were on par with year end. In contrast, tech stocks zoomed ahead always finding new highs. The last two weeks -- and particularly the last couple of days -- brought an end to this sharp disparity. With Friday’s close, the NASDAQ composite is down 18.5 percent from year-end levels. Any long term investor who came to this market last year is still probably seeing good returns on their investment. But investors who came in February or March are clearly in the red.

The Russell 2000 followed the path of the high tech market in the past couple of months and was gaining strongly with the NASDAQ composite. If you live by the sword, you can also die by the sword. The Russell 2000 fell about 35 points today and is down 10.1 percent from year end levels. While the Russell hasn’t fallen as sharply as the NASDAQ index, it only gained 19.5 percent last year as a whole. Thus, it has returned half of last year’s gain.

The Dow Jones Industrials plunged today – posting the largest point drop in a single day (although not the largest percentage decline.) After all that, the Dow is down 10.3 percent from year end levels, really not the worst showing this year. After today’s actions, the S&P 500 seems to have suffered the least blows. The S&P 500 fell nearly 84 points today, but is down 7.7 percent from year end.

Treasury yields benefit from stock rout
Sentiment was decidedly more bearish this week, particularly after Fed Governor Laurence Meyer said Wednesday that the rate hikes already implemented by the Fed since last June have had virtually no impact on consumer demand. He implied that the Fed should become more aggressive going forward to curtail this unsustainable growth. Meyer’s remarks were underscored the subsequent day by a blazing retail sales report for March. The CPI figures should have been negative for the bond market as well. Ironically, the sell-off in the stock market had investors fleeing to safe-haven investments. As a result, bond prices were lifted Friday as stocks were pummeled. Without the stock market plunge, bond yields would be higher reflecting the bond market’s expectations of a more aggressive tightening stance by the Federal Reserve.

 

Markets at a Glance
Treasury Securities	12/31/99	April 7	April 10	Weekly Change
30-year Bond	6.48%	5.71%	5.79%	+ 8 BP
10-year Note	6.43%	5.85%	5.90%	+ 5 BP
5-year Note	6.34%	6.19%	6.19%	unch
2-year Note	6.24%	6.36%	6.34%	- 2 BP
Stock Prices
DJIA	11497*	11111*	10310*	- 7.2 %
S&P 500	1469*	1516*	1357*	- 10.5 %
NASDAQ Composite	4069*	4446*	3315*	- 25.4 %
Russell 2000	505*	543*	454*	- 16.4 %
Exchange Rates
Euro/$	1.0008	0.9545	0.9606	+ 0.6 %
Yen/$	102.40	105.38	105.08	- 0.3 %
Commodity Prices
Crude Oil ($/barrel)	$25.60	$24.85	$25.40	+ 2.2%
Gold ($/ounce)	$289.60	$282.60	$284.80	+ 0.8%
(BP = basis points; stock price indices are rounded)

Price measures all point upward
The consumer price index jumped 0.7 percent in March after posting a 0.5 percent gain the previous month. Surging energy prices primarily contributed to the gains – rising 4.9 percent in March and 4.6 percent in February. Food prices were tame in March. Altogether this pushed up the CPI 3.7 percent versus a year ago. Excluding food and energy prices, the CPI increased 0.4 percent in March – twice as fast as gains over the past few months and twice as fast as expected by market participants. The core CPI now stands 2.4 percent above last March, the largest year-on-year gain since December 1998. It won’t go unnoticed by Fed officials.

The old nemesis, tobacco prices continued to post sharp gains in March, but analysts were probably more taken aback by a 0.5 percent gain in shelter costs. In February, housing costs rose 0.5 percent because of a whopping 28.2 percent hike in fuel oil. About a third of this hike was offset by a decline in March. However, higher hotel costs spurred a rise in shelter. It remains to be seen whether this is a one time blip.

But the unfavorable inflation news doesn’t stop with the CPI. The producer price index jumped 1 percent in March matching the February spurt. The magnitude of the increase was once again unexpected. Energy prices surged 5.8 percent in March after an already strong 5.2 percent rise in February. The only good thing about these gains is that the increased production plans coming out of OPEC have already started a slight downward trend in energy prices which may show up (to a small extent) in the April data.

Excluding food and energy prices, the PPI rose a more modest 0.1 percent in February, helped by declines in both tobacco and computer prices. On a year-over-year basis, the trend in the core PPI, as indicated in the chart below, is a bit more sanguine than the trend in the CPI data.

Market players have paid more attention to the PPI for intermediate goods and crude materials as lead indicators of finished goods price inflation. Excluding the volatile food and energy components, the intermediate goods index continues to post moderate gains and was up 3.1 percent in March from a year earlier. Nonfood, nonenergy crude materials fell 0.2 percent in March for the second straight month, but were still 16.3 percent higher than last year. On the whole, these figures don’t point to accelerating inflationary pressures at this point.

Our own analysis suggests that there is less of a leading quality to these indices. That is, in an inflationary environment finished goods, intermediate and crude materials all move in the same direction at roughly the same time. When inflationary expectations are not entrenched, price gains at earlier stages of production don’t automatically feed through to finished goods.

Import prices rose a modest 0.3 percent in March after gaining 2 percent the previous month. Prices for petroleum imports rose a meager 0.2 percent after surging 14.4 percent in February. Non-oil prices also rose 0.2 percent for the month. In any case, this boosted the total import price bill by 9.4 percent in March relative to last year, although non-oil prices are 1 percent higher for the year.

Export prices increased 0.4 percent and are 2.2 percent higher than a year ago. These prices are in line with the core CPI and PPI figures and confirm the rising trend.

The bottom-line on inflation? The March CPI data is really the worst among this week’s inflation reports. The bad news was not concentrated in the volatile energy component. The PPI figures and the import/export price data was somewhat less frightening for inflation-phobes. Nonetheless, the trends are generally pointing in the same (wrong) direction.

Federal Reserve officials won’t ignore these data. Indeed, the CPI figures alone increase the odds for a more severe rate increase of 50 basis points, rather than the 25 point gradualist approach.

Consumer spending afire
Retail sales rose a modest 0.4 percent in March. What a misleading picture of the consumer! Excluding autos, which declined from a record pace in February, sales jumped 1.4 percent in March after surging 1.8 percent in February. All told, the quarterly gain in retail sales shot up to a whopping 15.8 percent rate. The chart below reveals the increasing trend in retail sales. Granted, some of this gain is related to higher energy prices, and adjusting for this will bring down the overall retail sales pace moderately. Nonetheless, the evidence reveals quite a happy consumer.

Indeed, the University of Michigan’s mid-month reading on consumer sentiment rose in April to 110.2 from 107.1 in March. Preliminary April figures don’t quite take us back to January and February, but are showing an awfully optimistic consumer. It will be interesting to see how these figures are adjusted at month end when consumers feel the full impact of this month’s stock market correction.

The bottom-line on consumption? Fed Governor Laurence Meyer’s concern that the Fed’s rate hikes have had virtually no impact on demand would appear to be borne out – consumer spending has actually accelerated over the course of the past six to nine months since the Fed first began their series of rate hikes.

Federal Reserve officials are likely not amused by the robust pace of retail spending. In order to dampen activity they may feel compelled to accelerate their tightening process. A 50 basis point rate hike will likely be the main topic of discussion at the May 16 FOMC meeting.

Sluggish March masks strong quarterly production increase
The index of industrial production increased a modest 0.3 percent in March after a downward revised gain of 0.1 percent in February. March production was hampered by a 2.5 percent drop in utilities. Otherwise, manufacturing and mining advanced moderately. As a result of the strong showing in January, production growth accelerated in the first quarter. The chart below shows a clear upward trend over the past four quarters. The capacity utilization rate is also rising, which sometimes indicates the potential for supply bottlenecks and inflationary pressures. However, current levels are not quite foreboding.

THE BOTTOM LINE
Fed officials and market players have been waiting to see if strong economic demand would lead to a breakout of inflation. The March consumer price index was much worse than expectations and could be enough to seal the coffin on a 50 basis points rate hike when the Federal Open Market Committee meets on May 16. Fed officials have actually noted that strong consumer demand is a factor behind prior rate hikes. The fact that the rate increases already implemented have not moderated the consumer sector thus far may convince Fed officials that they need to be more aggressive in the future.

Looking Ahead: Week of April 17 to April 20
Market News International compiles this market consensus which surveys about 20 economists each week.

Tuesday
Market participants are expecting housing starts will drop 4 percent in March to a 1.71 million unit rate. At the same time, building permits are expected to decline a more moderate 0.2 percent to a 1.65 million unit pace. Higher mortgage rates of the past few months are likely to dampen demand at least modestly.

Wednesday
The market consensus is looking for the international trade deficit to widen in February to $28.5 billion from a shortfall of $28 billion in January. This represents a modest dip in exports coupled with another rise in imports.

Thursday
Market participants are expecting new jobless claims to rise 1,000 in the week ended April 15 from last week's 264,000 level.

Economists are predicting the Philadelphia Fed’s business outlook survey will dip to 20 in April from a level of 25 in March. This still presents a pretty decent level of manufacturing activity in this region.

The consensus for the federal budget is showing a deficit of $28 billion for the month of March. This would be a slightly larger deficit than the past couple of years, but small relative to the average for the 1990s.