Party pooper
Greenspan moves to stave off inflation, spooking stocks
Alan Greenspan's career as an economic seer, prodigious as it has been, might also be reduced to a series of cute acronyms. Start with WIN. That was the Whip Inflation Now campaign of the '70s when Greenspan headed President Ford's Council of Economic Advisers. Through much of his Federal Reserve Board chairmanship in the late '80s and '90s, Greenspan was an inflation hawk.
At the start of this decade, deflation and recession became the real bugaboos facing the economy. So Greenspan turned to a strategy that you could call SIN, as in Start Inflation Now, if only to get the economy going.
But now that the Fed has won the war on deflation and the economic expansion is more than three years old, the central bank's strategy is shifting once again--and the markets are getting woozy.
On the rise. This time, let's call it SPIN, or speak out about inflation now (while also downplaying its threat). This shift became clear last week when the Fed raised interest rates for the seventh time since June, bringing the federal funds rate--which banks charge one another on overnight loans--to 2.75 percent.
The Fed also did something it hasn't done for a while: warned investors about the "I" word. "Though longer-term inflation expectations remain well contained, pressures on inflation have picked up in recent months and pricing power is more evident," the Fed's Federal Open Market Committee said.
That sent the markets into a tizzy. The Dow Jones industrial average, which traded as high as 10,984 in recent weeks, sank to 10,430 following the Fed's move. "When the Fed worries about inflation and states so explicitly, you'd better believe the markets will worry about inflation," says Stuart Hoffman, chief economist for PNC Financial Services Group.
The downdraft continued with the price of crude oil hovering near $55 a barrel and consumer prices showing a rise of 0.4 percent in February, slightly above expectations. The new worry about inflation, and especially the notion that companies were starting to pass along increases in the cost of wholesale goods, has cast a pall over the stock market that some strategists believe could be a turning point for investors big and small.
While the ability to raise prices may be good for corporate profits in the short run, inflation is bad for consumers in the long run--and their spending accounts for some two thirds of the economy. Already, rising interest rates helped pushed mortgage rates above 6 percent for the first time since last summer.
Though rising rates are certainly good news for savers who are holding cash, fixed-income investors, especially those nearing retirement, face the daunting prospect of structuring bond portfolios just as interest rates are climbing. Higher rates lower the value of older lower-yielding bonds, which could lead to losses in fixed-income portfolios.
For investors in general, these are nervous times. Since 1972, the S&P 500 has typically lost ground in periods of rising prices. Financial and consumer discretionary companies, such as the automakers, tend to be hit the hardest during such times.
The markets appear to be adjusting to a Fed shift from a "speak loudly but carry a small stick" approach to a "big stick" solution. The Fed's statement was widely viewed as a warning that if prices rise noticeably, some sizable rate increases are to be expected down the road.
Indeed, over the past 50 years, the spread between the federal funds rate and consumer inflation has averaged 1.86 percentage points, says Tom Atteberry, assistant manager of the FPA New Income fund. With the consumer price index running around 3 percent annually, this means the Fed may eventually need to kick up the federal funds rate to at least 4.75 percent--2 points from where it now stands.
Rate hikes are a double-edged sword. They often nip inflation in the bud, but they also kill off economic expansions. To be sure, things are looking decent at present. The overall economy, for example, is expected to grow a respectable 3.6 percent this year. Corporate profit growth, while slowing noticeably, is still likely to set new records in dollar terms in 2005. And as the Fed pointed out, the economy "continues to grow at a solid pace despite the rise in energy prices."
Booming. Meanwhile, hiring is gradually improving, and the housing market continues to defy the experts. Last week, a government report showed sales of new homes soared 9.4 percent in February despite concern over mortgage rates. That was well above economists' expectations.
Anthony Chan, senior economist with J. P. Morgan Asset Management, has studied periods of rate hikes dating back to 1958. About two thirds of the times the Fed has raised rates since then, the U.S. economy fell into a recession either during the tightening cycle or within 24 months of the last rate hike.
While few are talking about the economy slipping into recession this year, 2006 is a big question mark. The economy has been growing for 3.3 years. That's slightly longer than the average expansion dating back to 1904. But three of the past six periods of economic growth lasted more than seven years each.
Since the stock market is a forward-looking indicator, should the economy threaten to slip into a downturn, it's likely the stock market would lose its momentum six to nine months beforehand.
This is in part why James Stack, editor of the InvesTech Market Analyst newsletter, says stocks are likely to finish the year lower than where they started. "I'm not expecting dynamic losses," says Stack. "But it's going to be a year of treading water."
Sam Stovall, chief investment strategist for Standard & Poor's, says he is "hard pressed to find reasons why this market will soar." He notes that the third year of market rallies tends to produce stock market gains of only 3 percent on average. And often, the stock market falls back into bear mode in that year.
Others aren't so pessimistic. For starters, even with last week's increase, short-term rates are still near 40-year lows. Moreover, many believe stocks are still attractively valued relative to bonds, which are most vulnerable to rising inflation and interest rates. "You have to look at what the alternatives are," says Mike Thompson, director of research at Thomson Financial. Since investors face the real possibility of losses if they buy bonds in a rising rate environment, stocks may outperform bonds for the foreseeable future.
At the end of the day, the test for the markets will be real inflation. History shows that consumer prices have to rise at an annualized pace of 4 percent or higher before stocks get slammed.
The latest Labor Department report, released last week, indicates that the overall CPI, while rising, has grown 3 percent over the past 12 months. But should oil and commodity prices remain high in the coming months, those rates could tick up. If that's the case, all bets are off for stocks.
The Fed ratchets it up
[Chart data are incomplete.]
Federal funds rate
May '04 1.0 pct.
March '05 2.75 pct.
Source: Federal Reserve
Graphic by Rob Cady-- USN&WR
This story appears in the April 4, 2005 print edition of U.S. News & World Report.