Evelina M. Tainer, Chief Economist, Econoday

Inflation news favorable; Greenspan hints of slow hand in tightening

Equities soar
The Dow Jones Industrial Average continues to post healthy gains this week. The market rose 200 points from a week ago – and a good portion of that jump came today on benign inflation news. The NASDAQ composite just about recuperated from its "minor plunge". The chart below shows the zigzag movement over the past two weeks, but by Friday’s close, the NASDAQ had pretty much returned to year-end levels but not its previous peak.

The S&P 500 and the Russell 2000 continue to follow the pattern set by the NASDAQ market. The Russell 2000 is so far showing the past gains – and has in fact surpassed its 1999 year-end level. A good portion of the growth in the Russell is coming from technology stocks.

Treasury market still in the doldrums
Inflation news was benign this week. Even Alan Greenspan didn’t seem intent on following an aggressive tight monetary policy in the next couple of months. But bond investors would have none of that. Any good news couldn’t sustain a rally in this bearish market. Small bits of bad news went a long way in depressing bond prices. As a result, yields are higher this week than last. Market players are pricing in at least two – and possibly three rate hikes by the Fed in the next six months.

The U.S. Treasury announced a buyback program that will begin in April. This formalizes the early plans they first discussed last year of buying back "off-the-run" securities in order to reduce their average cost on the national debt. Off the run securities are those that are not as liquid because they might be for odd maturities and therefore are not traded as frequently as current issues. For instance, the yield on a 28-year Treasury bond is probably higher than the yield on the most recent issue of the 30-year bond. Off-the-run issues are often good deals for bond investors who intend to hold the security until it matures. The government will run reverse auctions for the buyback program.

Markets at a Glance

Greenspan in the news again
Alan Greenspan’s remarks before the Economic Club of New York on Thursday night were widely anticipated by financial market participants. They had hoped that he would give a clue as to the direction of monetary policy in the upcoming months. Greenspan’s words weren’t necessary to indicate that the overheated consumer sector would lead the Fed to raise rates at least 25 basis points at the conclusion of the February 1 & 2 FOMC meeting. In the past week or so, market players have even convinced themselves that the Fed might raise rates by 50 basis points come February. This was an unlikely outcome given the Fed’s gradualist tendency – and the current state of economic conditions, which remain healthy and show little inclination towards inflationary pressures.

Greenspan spent a good deal of the presentation discussing how the economy has benefited by technology in the form of rapid information flows. When he finally touched on the issue of the economy, he noted that although this expansion will soon surpass that of the 1960s in longevity, "there remain few evident signs of geriatric strain that typically presage an imminent economic downturn."

Greenspan did note his concern that the soaring stock market was generating a lot of wealth. In turn, gains in wealth were faster than increases in income. This led consumers to increase their expenditures by borrowing and dis-saving. The main problem was that this course of action could soon lead to supply and demand imbalances. He implied that the Fed would like to ensure that forces would put supply and demand back in balance. The financial markets came away with the understanding that the Fed has already gone a long way in addressing these issues so that an aggressive policy would not be necessary.

Thus, Greenspan basically confirmed the Fed’s intention to raise rates, but gave the indication that the rate increases on the horizon may be smaller and fewer than those already priced in the market as of January 13.

Inflation news is favorable
Consumer prices rose 0.2 percent in December after taking into account a 1.4 percent spurt in energy prices and a 0.1 percent gain in food prices. Excluding these two volatile components, the CPI inched up only 0.1 percent in December. There were no particular special factors in the CPI that could indicate that inflation was understated – or overstated – for the month. The chart below depicts the year-over-year changes in the CPI and the so-called core CPI. A 13.4 percent surge in energy prices in 1999 caused the total CPI to accelerate from a year ago. However, the CPI less food and energy prices rose 1.9 percent in 1999 – 0.5 percent points less than the previous year.

It is interesting to see where the price increases were in 1999. Not surprisingly, transportation costs gained the most during the year, but this incorporates energy prices. The "other goods and services" category also jumped during the year – but this (small-weighted) category includes tobacco products where prices soared 11.4 percent last year. Among the remaining categories, medical care costs are rising faster than the total CPI; this problem dates back to the 1980s.

The producer price index also showed fairly good news on inflation. The PPI rose 0.3 percent, while the core PPI gained a more moderate 0.2 percent in December. These figures were in line with expectations. The surge in energy prices during the year caused the total PPI to post a year-over-year gain of 3.0 percent. This was the largest annual gain since 1990 and certainly a far cry from the past two years when prices declined! Excluding food and energy prices, the PPI was up a more moderate 0.9 percent in 1999 – less than the previous year, but not as good as 1997 when prices were unchanged.

Cash registers were ringing it in for the holidays
Retail sales were hopping in the fourth quarter. Total sales jumped 1.2 in December after a 1 percent spurt in November. Certainly a booming auto sector helped propel sales during these two months. Excluding the auto group, retail sales did posted a 1.4 percent hike in December! Some analysts thought that part of the spending might be due to Y2K stockpiling. That could be – to a small extent. After all, after averaging monthly increases of 0.5 percent for many months, food store sales jumped 2 percent. Did U.S. consumers fill up their pantries with Spam, Velveeta and Campbell’s Soup? Perhaps Americans were simply planning more in-home parties for the New Year rather than dining out. Spending at restaurants inched up only 0.4 percent in December after averaging faster gains in previous months. In any case, these are small potatoes compared with healthy gains across the board. Consumers couldn’t have been stockpiling furniture and other durables (jewelry) in the event of a Y2K crash, and these posted healthy gains as well.

Fed officials will worry that the healthy momentum of the fourth quarter could spill into the first quarter. The University of Michigan’s consumer sentiment index did jump to 111.4 in early January for an early reading on consumer optimism.

Industrial production ends year on good note
The Fed’s index of industrial production rose 0.4 percent for the second straight month in December. Most of the industry groups posted respectable gains – except for transportation where auto and light truck assemblies decreased for the month. Among durable goods manufacturers, computer and office equipment posted the largest gain. Among nondurable goods, tobacco products increased smartly for three straight months.

The chart below shows how the industrial sector turned around over the course of the year. Many economists are expected production to post solid growth in 2000 as export demand from Europe and Asia spurs domestic manufacturers. The capacity utilization rate, an indicator of resource limitation, was headed higher at year-end, but is far from the 85 percent flash rate that signals impending doom on inflation.

Retail sales suggest that consumer momentum was still going gangbusters at year-end. The early reading on consumer optimism showed the state of euphoria continues. This apparently is worrying Fed officials more than the current level of inflation. Indeed, the inflation figures weren’t a source of concern despite higher energy prices. Greenspan continues to worry about a soaring equity market that creates wealthy consumers – and fuels spending. So the cycle begins again. Financial market players are now anticipating a rate hike of 25 basis points for the upcoming FOMC meeting in early February.

We use the Market News Service survey of forecasts to describe the market consensus.

The Beige Book, a compilation of activity described to the Fed banks by businesses in their districts, will be widely anticipated by market participants. The Beige Book will include data through approximately January 10.