Armed with a steaming mug of double mocha latte, Ernest Hunter flicks his TV on to CNBC. It’s 8:32 in the morning, and as Ernie logs on to his direct access trading platform, he hears that the Producer Price Index is showing a sharp spike in inflation. Rising oil prices are to blame, according to CNBC’s macro data goddess Kathleen Hayes.
Boy, that ought to drive the market down, thinks Ernie. So he fires off an order to short a thousand shares of cubes, the tracking stock for the Nasdaq. Minutes later, his shorted cubes not only don’t go down, they go up—way up—and Ernie winds up losing almost $10,000.
Two days later, Kathleen Hayes reports on the latest Consumer Price Index numbers. Like the PPI, the CPI has come out very hot. But the culprit this time isn’t a spike in oil prices, says Kathleen, but rather a jump in the CPI’s core rate of inflation.
So what? thinks Ernie. He won’t be fooled again. So this time he goes long a thousand shares of cubes. Only problem is, this time the Nasdaq goes down on the inflation news…and down…and then down some more. At this point, Ernie is beginning to hate Kathleen Hayes.
Hey, Ernie, don’t shoot the messenger. Just understand Kathleen Hayes’ message. Here it is: When stalking the inflationary tiger, the macrowave investor must first be aware that there are at least three species of this very dangerous beast.
First, there is the demand-pull variety that comes with economic booms and too much money chasing too few goods. This tiger is perhaps the easiest to tame—although with inflation, nothing is ever truly easy. Second, there is the cost-push variety that results from so-called supply shocks like oil price hikes or drought-induced food price spikes. This inflation moves with deadly swiftness, inflicts great pain, and often gives the Federal Reserve fits. Finally, there is wage inflation. It can be the most dangerous of all, slow and plodding though it may be; it can be triggered by either demand-pull or cost-push pressures.
Now here’s the broader point: If, like Ernie in our little story above, you are unable to quickly and clearly distinguish between these three species of inflationary tigers, you will be prone to misinterpreting the real message of inflation indicators like the Consumer Price Index and the Producer Price Index. The likely result will be that one of these inflationary tigers will eat your trading capital for lunch, belch loudly, and then move on to its next victim with nary a thank you. This will be true for one very simple reason: In the face of inflationary news, both the Federal Reserve and Wall Street are likely to react quite differently depending on which species of the inflationary tiger they actually fear. If you get caught on the wrong side of such a reaction, you will be doomed! That’s why, right now, we need to roll up our sleeves and dig into some inflation theory.
Big Government, Big Labor and Big Business all accept the notion that no one should lose ground to inflation. So does the average worker, whether an executive or a janitor. The result is a series of practices and customs that make the basic inflation rate the floor for most wage increases.…
THE NATIONAL JOURNAL
In modern industrial nations like the United States, most economists believe that there is a core or inertial rate of inflation that tends to persist at the same rate until some kind of shock comes along to change things. At the heart of this idea of core inflation is the concept of inflationary expectations. Inflationary expectations are important because the expectation of inflation can significantly contribute to actual inflation. The reason is that inflationary expectations strongly influence the behavior of businesses, investors, workers, and consumers.
For example, during the 1990s, prices in the U.S. rose steadily at around 3 percent annually, and most people came to expect that inflation rate. This expected rate of inflation was, in turn, built into a core rate of inflation for the economy through institutional arrangements such as negotiated labor contracts. To see how this happens, suppose that an economics forecaster like Standard & Poor’s DRI predicts that the rate of inflation for the coming year will be 3 percent—the same rate as the previous year. Further suppose that labor negotiators at the United Auto Workers union believe that workers will achieve a 1 percent increase in productivity. Because increases in real wages are tied to labor productivity, this means that autoworkers arguably deserve a 1 percent increase in their real, inflation-adjusted wages. Therefore, under these conditions, the union negotiators will demand a minimum 4 percent increase in the nominal wage—1 percent to get the real increase based on productivity gains and 3 percent to adjust for the expected or forecast inflation.
Now, when Ford, General Motors, and DaimlerChrysler all agree to this 4 percent wage demand, the increase in wages caused by the union’s inflationary expectations will lead to an actual increase in the auto industry’s labor costs. This, in turn, will put upward pressure on auto prices so that the expectation of inflation becomes a self-fulfilling prophecy, and the inertial or core rate of inflation is maintained.
From this little story, you can see that once inflationary expectations are built into an economy, they are very hard to eliminate. The reason is that people tend to assume that inflation will continue to be what it already is, and they will behave accordingly—a phenomenon known as adaptive expectations. From this little story, you can also see the intimate relationship between inflation at the retail level where, for example, cars are sold, and wage inflation at the wholesale level, where cars are manufactured.
Now the broader point of this story is that at any given time, the economy’s inertial or core rate of inflation tends to persist until a shock causes it to move up or down. The next question is: What kinds of shocks might cause the inertial rate to move? The answer is either demand-pull or cost-push inflation.
If Alan Greenspan has someone to thank for his rock-star status, …it is surely William McChesney Martin. He ran the Fed under five presidents (Truman, Eisenhower, Kennedy, Johnson and Nixon) and seems to have had a generally low opinion of presidential economic acumen.… When in 1965 he decided to raise interest rates to try to stave off inflation brought on by the Vietnam War, Lyndon Johnson called Mr. Martin to his ranch in Texas to berate him about the political consequences of a rate rise. Mr. Martin stood firm. The Fed had to “lean against the wind” of inflation, he said. His job, as he famously quipped, was to “take away the punch bowl just when the party gets going.”
THE ECONOMIST
Right up until the Vietnam War in the 1960s, inflation was largely viewed as a demand-pull phenomenon. That is, when there was a general rise in the price level, it was typically attributed to excess aggregate demand—too much money chasing too few goods in a booming economy. In this sense, demand-pull inflation is a very bullish phenomenon, and all the more so because it is more readily curable using either contractionary fiscal or monetary policies—or so the Keynesian theory goes.
Indeed, from a Keynesian perspective, all the party-pooping Federal Reserve has to do to fight demand-pull pressures is to take away the proverbial punch bowl. How does it do so? Simply by raising interest rates. And if all goes well, the economy will come in for a very nice soft landing as demand-pull pressures ease.
Alternatively, to fight demand-pull inflation, Congress and the President can apply contractionary fiscal policy by either cutting spending or raising taxes. However, with fiscal policy, the effects take a much longer time to take hold and the outcome is much more uncertain. That’s why fighting demand-pull inflation usually falls in the Federal Reserve’s lap.
The Fed has raised [interest] rates six times…to the highest level in nearly a decade. The economy’s continued strong performance has policy-makers fearing inflation.… [But] higher energy costs may have the same impact as a tax [increase] or [interest] rate hike. That would argue against further Fed tightening. Higher prices for airfares and natural gas simply limit the purchasing power in some other sector of the economy.
INVESTOR’S BUSINESS DAILY
Now let’s contrast the demand-pull situation with supply shock or cost-push inflation, and let’s use the now infamous supply-side shocks of the early 1970s to help illustrate this concept. During those years, the economy was hit by dramatically higher oil prices due to the Arab oil embargo and higher food prices due to an El Niño weather condition. At the same time, the Nixon Administration moved to a flexible exchange rate, the dollar’s value fell precipitously, and this likewise raised business costs. Taken together, these supply-side or cost-push shocks put a severe crimp in the American economy’s ability to produce.
Let me show you what I mean with a picture of how cost-push inflation winds up hitting the economy with the double whammy of stagflation. Figure 15-1 illustrates the economy before and after a supply-side shock. In the left-hand side graph, the horizontal axis measures the economy’s output or gross domestic product, while the price level or level of inflation is measured on the vertical axis. In addition, aggregate demand in the economy is measured by the downward-sloping AD curve while the economy’s ability to produce is measured by the upward-sloping aggregate supply curve AS. Note the intuition behind these supply and demand curves. Higher prices for their products mean businesses will produce more, so the aggregate supply curve slopes up; but higher prices also mean consumers will demand less, so the aggregate demand curve slopes down.
FIGURE 15-1 Cost-push inflation.
Now, the graph on the left side illustrates the economy before the supply-side shock. It is in equilibrium at point Q1 where the supply and demand curves cross. At this point, the price level in the economy is at a modest level of P1, and everyone is fully employed. But now take a look at the right-hand graph. This shows what happens after a supply-side shock like higher oil prices hits the economy. This shock shifts the aggregate supply curve, AS1, inward to AS2 because business costs are now higher. And note that this shift causes two things to happen—both of them bad.
First, the economy’s output falls to Q2 as the economy falls into a recession. Second, and simultaneously, the price level rises to P2. In other words, we get both recession and inflation at the same time. This is a classic case of cost-push inflation, and you can see how, if it persists, it can lead to the deadly economic disease of stagflation—recession and inflation.
In this sense, cost-push inflation is much more of a bearish kind of inflation than demand-pull. The problem is that there is no simple Keynesian policy solution to cost-push inflation. Using either expansionary fiscal or monetary policy to reduce unemployment and end the recession will only create even more inflation, while using contractionary policy to curb inflation will just plunge the economy deeper into the recession. This is precisely why cost-push inflation can give the Federal Reserve such fits. Indeed, in the presence of cost-push inflation, the Federal Reserve is often as helpless as a baby caught in a riptide. More important, the Fed also knows that this kind of inflation has a much different impact on the economy than demand-pull inflation.
A case in point is offered up by the events of the year 2000. In that year, the Fed suddenly found itself fighting both cost-push and demand-pull inflation. The demand-pull inflation was, of course, the result of years of an economic boom. The cost-push inflation began to surface, however, primarily in the form of rising energy prices. At the root of this problem was the OPEC cartel. It began to ratchet oil prices up sharply, and as the cost of a barrel of oil zoomed towards $40, gasoline prices sprinted for the $2-a-gallon mark.
Now what is most interesting about these two conflicting forces of demand-pull and cost-push pressures was that Fed Chairman Alan Greenspan was smart enough to understand that at least in some perverse sense, OPEC was actually helping the Fed do its job of bringing the economy under control. The reason is that OPEC’s oil price shocks acted in much the same way that contractionary fiscal policy in the form of higher taxes works on an economy. In this case, as oil prices rose, consumers had to spend more of their money on energy. But that meant that they had less money with which to buy goods being produced in other sectors of the economy. That, in turn, meant lower consumption and less stimulus for the booming economy. So the Fed could be less aggressive about raising interest rates to fight demand-pull inflation.
The broader point here, and one that brings us back to our earlier story about Ernest Hunter, is this: While the Fed is likely to very swiftly raise interest rates when demand-pull inflation is pushing up the core rate of inflation, the Fed is much less likely to raise interest rates when supply-side shocks like rising energy prices are creating cost-push inflationary pressures. That’s why the Fed always tries to determine what kind of inflation is pushing up our economic indicators before it decides on a course of action to take. And that’s why the savvy macrowave investor always goes through the same thought process as a means of anticipating the Fed’s actions.
These points lead us to a discussion of the third species of inflation. Wage inflation tends to occur in the later stages of an economic recovery, usually as a result of demand-pull pressures. At this stage in a recovery, labor unions, in particular, will likely see their bargaining power rise to a maximum. The resultant labor negotiations may yield large wage increases that, in turn, may ripple through other industries. In addition, as labor markets in the nonunion sector get tighter and tighter, firms will begin to bid against one another for workers, likewise driving wages up.
Note, however, that wage inflation can also be driven by cost-push pressures. In fact, way back in the 1970s when stagflation reigned supreme and inflation soared into the double digits, a number of key labor unions were able to successfully negotiate the inclusion of cost of living adjustment clauses into their contracts. The result of these so-called COLAs was that as cost-push inflation soared, wages were automatically driven up. The irony, of course, is that these higher wages led to higher consumer prices, fewer sales, faster layoffs, a deepening recession, and much higher unemployment.
Now the point here is simply this: Whether it is from demand-pull or cost-push pressures, any sign of wage inflation is likely to be met with the strongest of Fed responses and the harshest of market reactions. This is because both the Fed and the Street know that wage inflation usually occurs in the more advanced stages of the inflationary cycle. Because of this, the Fed and the Street also know that wage inflation will typically require the strongest medicine to cure and take a much longer time to cure than simple demand-pull inflation.
It follows from this discussion that when inflation starts to rear its ugly head, discretionary fiscal and monetary policies cannot be too far behind. And for the stock market, that always means trouble. The particular kind of trouble, however, will be a function of the particular kind of inflation the Fed and the Congress and the White House are forced to fight. That’s why the major inflationary indicators, which are listed in Table 15-1, are so important to watch. These indicators include the Consumer Price Index, the Producer Price Index, the GDP deflators, average hourly earnings, and the Employment Cost Index. Note that in the table each indicator is ranked with from one to five stars. Five stars indicate the strongest reaction from the stock and bond markets, while one star indicates the least reaction.
TABLE 15-1. The Major Inflation Indicators
Consumer prices surged in March, reflecting higher costs for everything from gasoline to housing. The unexpected news on inflation triggered the worst one-day point drop in Wall Street history.… Most troubling to investors and economists: the core rate of inflation, which ignores volatile food and energy prices, jumped by the largest amount in five years.
SOUTH BEND TRIBUNE
The Consumer Price Index or CPI is the ultimate inflation tea leaf. It is arguably the most closely watched and important of the major inflation indicators, with a clear five-star rating, and any unexpected change in the CPI is likely to have a major impact on the stock and bond markets.
The latest CPI data are released by the Department of Labor between the 15th and 21st of every month. As with many economic indicators, the data are always released at 8:30 a.m. Eastern Standard Time before the stock market opens. The CPI measures inflation at the retail level. It is a fixed-weight index that tracks the average price change over time of a fixed basket of goods and services. The pie chart in Fig. 15-2 illustrates the major categories of goods and services and shows the relative importance of each category. Note that the largest CPI category by a very large margin is housing, accounting for roughly 40 percent of the index. It is followed in importance by transportation, food and beverages, recreation, education, and medical care.
FIGURE 15-2 Slices of the CPI pie.
When analyzing the CPI data, Wall Street analysts are very careful to concentrate on the CPI excluding food and energy. This care speaks to the importance of distinguishing between demand-pull inflation, which is likely to spur the Federal Reserve to raise interest rates, and cost-push inflation, which may make the Fed much less likely to raise rates. In this regard, Wall Street views the CPI excluding food and energy as the best measure of the economy’s core rate of inflation. If this is rising, it usually means demand-pull pressures are building, and the Fed is more likely to take away the punch bowl. That’s why in our example leading off this chapter Ernest Hunter made such a serious mistake. He should have interpreted a rise in the core rate as very bad news likely to move the market down—a clear sign to go short. Instead, he went long, and it wound up being his trading capital that got a lot shorter.
As for the impact of higher food and energy prices on the CPI, the thing you need to know here is that these prices are not only highly volatile, they are often symptomatic of cost-push inflation. As we now know, this kind of inflation cannot be cured by raising interest rates to cool off the economy. In fact, cost-push inflation is recessionary in and of itself. If the Fed tries to cure it with an interest rate hike, the only result will be a greater recessionary shock.
Now, here’s a more subtle but equally important point about the CPI. Unlike the Producer Price Index that you are about to meet, the CPI includes imported goods in its calculations. This is particularly useful to know during times when the value of the dollar is fluctuating rapidly, because during such times the CPI can generate misleading inflationary signals. The problem is simply this: If the dollar is depreciating rapidly, this will drive the cost of imports up and move the CPI up. However, this kind of inflation will likely be viewed as far less troublesome by the Federal Reserve than, say, a similar rise in the cost of domestic goods.
The producer price index, which measures inflation at the wholesale level, rose 0.6% in June—a bit more than expected and 4.3% year over year. The culprit was higher energy prices, which jumped 5.1% for the month. But core PPI, which strips out the volatile food and energy sectors, actually fell 0.1% for the month. That was better than expected. The drop is likely to soothe the nerves of the inflation wary Federal Reserve.
INVESTOR’S BUSINESS DAILY
While the CPI measures inflation at the retail level, the Producer Price Index or PPI measures inflation at the wholesale level. It is based on over 30,000 commodities and more than 10,000 price quotes. The PPI data likewise are released by the Department of Labor, usually around the 11th of each month for the prior month.
In terms of Wall Street reaction, the PPI ranks at least one star below the CPI. However, for the macrowave investor, the PPI is, in many ways, much more interesting. This is because changes in the PPI often foreshadow changes in the CPI—at least over the longer term.
To see this, we need to understand that the PPI is actually three indexes rather than one. The first PPI reflects prices of crude materials such as grains, livestock, oil, and raw cotton. A second PPI reflects prices of partially processed intermediate goods like flour, leather, auto parts, and cotton yarns. The third PPI looks at finished goods such as bread, shoes, autos, and clothes that are available for sale at the wholesale level.
Technically, each PPI beginning with crude materials can be seen as a leading indicator of changes in the next PPI. For example, an increase in the cost of a crude material like grain will soon show up as an increase in the cost of an intermediate material like flour, and soon thereafter this higher intermediate good cost will be reflected in the cost of a finished good like bread. It is perhaps for this reason that when you read about the PPI in the news or see it discussed on CNBC, the reporters and analysts are usually referring to the finished goods PPI. It is also this finished goods PPI that gets the most attention and reaction on Wall Street.
The pie chart in Fig. 15-3 shows the relative importance of each of the major categories of finished goods in the PPI fixed-weight index. The capital goods slice of the pie includes equipment and machinery, as well as civilian aircraft. In the nondurable consumer goods category, we have necessities like clothes, electricity, and gasoline, while in the durable goods category, we have big-ticket items like cars and trucks.
FIGURE 15-3 Slices of the PPI pie.
Perhaps the most interesting thing to note about this pie chart is that the finished goods PPI is heavily weighted toward consumer goods. Because of this, there is a tendency among the less savvy on Wall Street to extrapolate changes in the PPI to changes in the CPI. Note, however, that this can be a very dangerous thing to do, at least from month to month. In particular, if you try to use this month’s PPI numbers to predict changes in this month’s CPI, and then use that prediction to enter a trade, you may be in for a very rude surprise.
The reason why this can be hazardous to a trader’s health is that, at least on a month-to-month basis, the PPI and CPI are not particularly well correlated. This is partly because the PPI is more volatile than the CPI, but it is mostly because of two key differences in the CPI and PPI weighting schemes. In particular, the PPI reflects the cost of very few services, whereas services account for more than half of the CPI. In addition, the actual weights used in the PPI for different goods are very different from those used in the CPI. For these reasons, at least in the short run, there can be considerable divergence between the CPI and the PPI.
Having said this, it is nonetheless true that over the longer time frame of a few months or a year, the two indexes are much more highly correlated, so in a very real sense the PPI does give you an earlier heads-up on inflation than the CPI. That’s why, in many ways, the PPI is a better inflation indicator than the CPI and why a macrowave investor with a longer-term horizon will find watching this indicator so very useful.
Now, let me make several other macrowave investing points about the PPI before we move on to our next inflation indicator. First, as with the CPI, Wall Street tends to focus on the PPI excluding food and energy, and for the same reason. Both the energy and food components of the PPI are highly volatile. They can go up for a few months and then come right back down. Accordingly, the PPI excluding food and energy is a much better measure of the core rate of inflation and demand-pull inflation, and the Street knows that the Fed is more apt to react much more strongly to demand-pull pressures than to cost-push inflation due to energy or food spikes.
To relate this crucial point back to our earlier story about Ernest Hunter, recall that when the PPI numbers came out hot, Ernie shorted the market. However, this turned out to be a really big mistake. That was because the inflationary spike was due merely to a boost in energy and food prices, while the core PPI rate was relatively cool. The market took this as a very positive sign that the Fed would not boost interest rates further and rallied. Of course, Ernie lost a bundle because he didn’t understand this.
Now, as a second macrowave investing point, you should also be aware that the PPI is sometimes prone to volatility spikes even after food and energy are excluded. For example, auto prices tend to jump up in the fall with the introduction of new models, while tobacco prices can spike at least several times a year. These kinds of price spikes can buffet the PPI in a way that generates false inflationary signals. So when you review the PPI, don’t just swallow the whole finished goods number, take a look at each of the categories and try to determine where any movements are coming from. Obviously, Alan Greenspan and the Fed are not going to stress out over a PPI spike caused by a tobacco blip.
The stock market headed lower yesterday in more active trading due to a sharp drop in bonds and the dollar, which in turn sparked program selling.… “The gross domestic product deflator was up more than expected and that bombed bonds, which in turn bombed stocks,” said market analyst Alfred Goldman of A.G. Edwards Inc. in St. Louis.
INVESTOR’S BUSINESS DAILY
The GDP deflators are the broadest measures of inflation. They cover price changes for over 5000 items in every sector of the economy, from consumer products and capital goods to foreign imports and the government sector.
In all, there are three GDP deflators—a chain-price index, a fixed-weight deflator, and an implicit deflator. They are reported quarterly as part of the broader report on the gross domestic product, which is issued by the Department of Commerce on the third or fourth week of the month after the end of the quarter.
In the greater scheme of things on Wall Street, the GDP deflators are of only mild interest, rating no more than two, or perhaps three, stars. At least part of the reason is that the deflators are only reported quarterly rather than monthly. Also, they are generally regarded as lagging, rather than leading, indicators. In assessing the impact of the GDP deflators on the financial markets, it is important to know that these deflators typically reflect a lower rate of inflation than the CPI. This is because the prices of capital goods, which are included in the GDP deflators but not in the CPI, tend to be less expensive than consumer goods. Having said this, all three key inflation indicators—the CPI, the PPI, and GDP deflators—all tend to move in the same direction over time.
Now, here’s a second important macrowave investing point. The GDP deflators can react quite deceptively, as well as very counterintuitively, to a spike in the price of imported oil or other imported goods. The reason: All goods and services not produced in the U.S. such as imported oil are subtracted from the GDP—remember that the “D” in the GDP stands for “domestic.” Now here’s the problem with this: When import prices rise, a greater dollar value of imports is taken from the GDP and the deflator goes down. Frankly, this is just plain goofy, since both consumers and businesses are paying higher prices for their imports and it would seem that any inflation index worth its salt should reflect that. But the GDP deflator doesn’t—so just be on the lookout for this kind of problem when you evaluate the data.
An unexpected spike in an important inflation warning signal that tracks labor costs spooked financial markets yesterday.… [B]oth the stock and bond markets fell sharply after the Labor Department reported that the employment cost index rose 1.1 percent from the first to the second quarter of the year, its biggest gain in eight years.
THE NEW YORK TIMES
While the CPI and PPI are appropriate instruments to ferret out whether inflation is of the demand-pull or cost-push variety, there are two additional economic indicators that are absolutely essential in revealing the presence of wage inflation. These indicators are the Employment Cost Index and average hourly earnings. Both should be closely watched by the macrowave investor, but be forewarned—both also contain their own traps for the careless conclusion and ill-timed trade.
The Department of Labor reports average hourly earnings one week after the end of every month as part of the broader jobs report. Because these are usually the first inflation data of the month, Wall Street eagerly awaits the average hourly earnings news. There are, however, at least three major problems with these data, and being unaware of them can get a macrowave investor’s capital balance into deep trouble.
One problem is that a sharp increase in overtime hours in any given period can send a false signal that wages are rising. This is because of the way average hourly earnings are calculated. It’s simply total payroll divided by total hours worked, as reported by each industry. This means that if a worker puts in 40 hours of regular time and another 5 hours at time and a half pay, average hourly earnings will rise even though the worker’s base wage hasn’t. A second problem that can likewise generate a false inflationary signal is that average hourly earnings do not adjust for changes in the composition of workers. Thus, for example, if manufacturers begin to substitute higher-skilled and higher-paid workers for lower-paid workers, it will appear that wages are rising when, in fact, the only thing that has changed is the composition of the work force.
Because of these two problems with accounting for overtime and the composition of the labor force, the average hourly earnings numbers can be highly volatile, and no self-respecting macrowave investor should ever take them at face value, much less base a major trade on them. Still, the third problem with the average hourly earnings data may be the most serious.
In particular, the average hourly earnings yardstick only measures wage changes while ignoring changes in benefits. However, in the modern labor market, benefits ranging from vacation and sick pay to insurance and retirement plans have become an increasing part of the total compensation package. As a practical matter, this means that even if wages are rising very slowly, rapid increases in the benefits package can still signal significant wage inflation. That’s why both Wall Street and the Federal Reserve value the Employment Cost Index as a second important indicator of wage inflation. It counts both wages and benefits. Indeed, even though this index is only reported quarterly, it has entered the top tier of economic indicators ever since the chairman of the Federal Reserve first extolled its virtues in 1995.
As a final point on the Employment Cost Index, even though it is less volatile than average hourly earnings, it nonetheless can be subject to occasional misleading spikes as well. Thus, it is important to always review these numbers within the context of the trend, as well as the broader economy. In this regard, note that a wage spike in an overheated economy is more likely to be a true signal of wage inflation than a similar spike in a cooling economy.
For the stock market, the final score of last week’s barrage of economic news seemed to be Bulls 9, Bears 4.… Nine of the week’s reports suggested the economy is slowing and inflation is not a problem. Four left some doubt as to just how slow that is, and whether inflation is really as benign as it seems. Those reports, and others to be released in coming weeks, will weigh heavily in the Federal Reserve’s decision to raise or not raise interest rates again when its policy-making committee meets May 20 and 21.
THE ATLANTA JOURNAL AND CONSTITUTION
While the indicators we have discussed measure the rate of inflation directly, there are a myriad of other more indirect economic indicators that can be useful in reading the inflation tea leaves. In fact, in an overheated economy in which inflationary pressures are percolating, Wall Street will carefully watch other economic indicators from retail sales and industrial production to housing starts, durable goods orders, and capacity utilization. In such a boom context, any sign of a slowdown in these indicators short of a full-blown recessionary signal will be considered anti-inflationary and good news on Wall Street—often to the dismay of Main Street. That’s why the prudent macrowave investor follows all the different economic indicators.
Now let’s turn to a discussion of how the stock, bond, and currency markets react to inflationary news. And let’s start with the stock market. This is simple.
Any inflationary news that increases the probability that the Federal Reserve will increase interest rates or tighten the money supply will drive stock prices down, along with the broader Dow and Nasdaq indexes. This is because higher interest rates augur lower earnings. End of story.
As for the bond market, this is a bit more complicated. This is because the specter of a Fed rate hike can have both an interest rate effect and an equity effect on bond prices. Moreover, each of these two effects pushes bond prices in the opposite direction so the net effect of inflationary news on the bond market is not always predictable. In this regard, the interest rate effect is most direct. It stems from the fact that the prospect of a Fed rate hike will push bond prices down as yields on existing bonds must rise to match the rate increase. On the other hand, the prospect of a Fed rate hike may drive panicky investors away from the stock market into the relative safety of bonds—the so-called “flight to quality.” The resultant equity effect will push bond prices up because of increased demand for bonds.
In fact, we saw a classic example of this phenomenon during the April 14th Nasdaq crash in the year 2000. When the CPI numbers came out very hot in the morning, bond prices immediately plummeted on fears of a Fed rate hike—that was the interest rate effect working. However, as panicky investors bailed out of the stock market into bonds, bond prices recovered nicely and actually closed up for the day—that was the equity effect. The broader point is that the macrowave investor will be very aware of these two conflicting forces.
As for the currency markets, the prospect of a Fed rate hike will tend to drive the value of the dollar up, at least in the short run. This is because higher interest rates in the United States will attract additional foreign investors into the U.S. bond market. However, before a foreign investor can buy U.S. bonds, she must first convert her yen or euros or pesos into dollars. This increases the demand for dollars and therefore puts upward pressure on the dollar.
Of course, we know all of this about the stock, bond, and currency markets from earlier chapters of this book. But what we really don’t know yet is the all-important answer to this question: Which sectors of the stock market are likely to be the most reactive and which are likely to be the least reactive to inflationary news? At least one answer to this question may be found in Table 15-2. This table is based on the results of a study I conducted with a colleague at the University of California. In this study, we examined how the stock market has historically reacted to major announcements of unexpected changes in the core rate of inflation. In our sample, we included events in which the inflationary news was unexpectedly bad, as well as cases in which it was unexpectedly good. What we found was a very predictable and systematic reaction among the various sectors to such news.
TABLE 15-2. How Selected Stock Market Sectors React to Inflation
Take a look at Table 15-2 to see what I mean. From the table, you can see that the results are quite intuitive. For example, in the most reactive column, the banking, brokerage, financial services, and home finance sectors all sell products whose price is essentially measured by the level of interest rates. When the expectation of higher interest rates goes up, so, too, does the expected price of the sectors’ products—whether these products are a loan for the banking industry, margin interest on stocks for the brokerage sector, or credit card carrying charges for the financial services sector. And as the prices of these products rise, fewer loans are issued, fewer stocks are traded, fewer credit card purchases are made, and the profits in these sectors fall. Of course, as expected profits fall, so, too, do stock prices.
Now, what about those sectors in the most defensive column? Looking over these sectors, you can see that the results are equally intuitive. For example, both gold and oil are generally regarded as excellent inflation hedges, meaning that in times of rapid inflation, they are likely to hold their value much better than a depreciating currency. The same is true to a lesser extent for commodities like industrial materials.
Now, looking at Table 15-2, it should be obvious as to how you can take this kind of information to the macrowave investing bank. Indeed, armed with this kind of information, you will be much better prepared to trade on the anticipation of inflationary news. For example, suppose the latest CPI numbers are about to come out, and you are very concerned that they may be unexpectedly hot. In such a case, you might want to go short on some weak stocks in the banking or brokerage sector. Alternatively, if you are holding stocks in any of the most reactive sectors, you might want to simply go flat or move into stocks in the most defensive sectors. The point is, such information can help you be like Jack of the old nursery rhyme—both nimble and quick.