Wednesday, June 14, 2006

Uncertainty, inflation data, and financial markets

We now have new data on inflation, both PPI and CPI indexes have been released by the BLS. The PPI, producer price index, is a measure of price changes from the prospective of the seller, whereas the CPI, consumer price index, is a measure of price changes from the prospective of households. What should we gather from the large amount of information released by the BLS?

Let's start from the PPI, released yesterday. The PPI increased by 0.2% in May after a 0.9% increase in April and a 0.5% in March. What does this mean? A 0.2% is not a big increase, but it is the series of increases that may worry the Fed. From May 2005 to May 2006 the PPI increased by 4.5%. This is a value outside the confort zone of the Fed. But, does a 0.2% reading means that inflation is slowing down, possibly due to contractionary monetary policy finally kicking in? This is not so sure. If we focus on PPI of intermediate goods used in manufacturing, the index increased by 1.1% in May, after a 0.9% increase in April, and a -0.1% in March. To the extent that increased prices of intermediate goods are passed on to prices of final goods, this increase implies a future increase in inflation.

Now the CPI, released today. The CPI increased by 0.4% in May and by 4.3% from May 2005. During the first 5 months of 2005 the CPI has increased at an annualized rate of 5.2%. Contrast this number with a 3.4% increase in the CPI in all of 2005. Excluding food and energy, the index increased at an annualized rate of 3.1% in the first 5 months; this is core inflation. The main drivers seem to be transportation (caused by increasing energy prices), medical care costs, apparel, and, perhaps more importantly, housing rentals. Both rents and owner equivalent rents have increased in May, by 0.3% and 0.6% respectively.

The data on inflation confirms some of the fears Mr. Bernanke had expressed: inflation is moving within bands that we have experienced in the recent past, but it's getting outside the Fed's confort zone. At the same time, spending and economic growth seem strong, both in the US and globally. It seems almost certain, as futures on the federal funds rate show, that the Fed will increase interest rates.

How have stock market reacted? On one hand you have strong growth, on the other rising inflation. This is an environment of uncertainty. If inflation rises, it means that high levels of growth cannot be sustained any longer, the economy is near or at full capacity. The fact that markets have dropped in the last week or so means that valuations are adjusting to a new, lower, level of growth. As the same kind of data is emerging more or less globally, and most noticeably, Japan and Europe, global financial markets are reacting in a similar fashion. Emerging markets indexes have also declined, and by more than the DJIA. This fact should not surprise. Growth in these markets is clearly related to growth in major countries such as the US, Japan, and Europe. In addition, these are riskier markets, so we should not be so surprised that benchmark indexes are down 9% in Russia and Colombia, or 5% in Turkey.

The climate of uncertainty has hit commodities too, with gold futures down 7% yesterday and 22% in the last month. Incidentally, commodity prices going down should indicate that expectations of inflation are not rising.

In conclusion, it seems that financial markets are not uncertain about what the Fed will do and about the Fed's ability to control inflation. Markets are uncertain about what's happening to growth, and what growth rate can be sustained in the near future.


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