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Fed to change its tune?
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May 14, 1999: 3:42 p.m. ET
Some experts smell rate hike after unexpected surge in consumer prices
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NEW YORK (CNNfn) - Last month's jump in retail prices may not push the Federal Reserve to raise interest rates next week but will probably force the central bank to lean in that direction, economists said Friday.
The Labor Department report that consumer prices rose 0.7 percent in April -- the biggest rise in more than 8-1/2 years -- means inflation is suddenly a threat again after months of strong economic growth with hardly any increases in prices and wages, a combination that many economists were calling remarkable.
Now, analysts say, all eyes will be on next week's Fed meeting to see if Chairman Alan Greenspan and his fellow policy-makers will move toward raising short-term interest rates.
"Once again, Greenspan was right," said Rob Palombi, a senior analyst at Standard & Poor's MMS. "Given that a number of Fed officials have been warning about rising inflation, we could see some insurance soon in the form of a rate hike."
The April inflation data took investors by surprise -- analysts had forecast a much smaller 0.4 percent rise last month -- and stocks and bonds tumbled on the news. Long-term interest rates in the Treasury market soared.
"The market was certainly not prepared for these numbers and it's magnified the rate issue in people's minds," said Mark Wanshel, senior economist at J.P. Morgan in New York.
The Dow Jones industrial average fell 185 points to 10,922, a drop of 1.7 percent, in midafternoon trade on Friday. In the bond market, the 30-year Treasury tumbled 2-3/8 points, or $23.75 on a $1,000 bond, sending its yield soaring to 5.93 percent from 5.75 percent late Thursday. The drop in price was the biggest in nearly three years and it sent the 30-year yield, which moves in the opposite direction from the price, to the highest level since May 1998.
Riding on rate cuts
The Fed cut short-term rates three times late last year in a bid to protect the U.S. economy from the turmoil overseas.
Since then, the Dow industrials have jumped almost 2,000 points and the yield on the benchmark 30-year Treasury bond fell as low as 4.71 percent. The question now is whether Fed officials will be as quick to raise rates as they were to cut them last year. Lower rates tend to spur economic growth, thus boosting corporate profits and justifying higher stock prices, while higher rates have the opposite effect.
There is ample evidence pointing to very strong economic growth that some experts have argued would inevitably lead to higher inflation. Unemployment remains at a record low. Consumers are picking store shelves clean at a frenetic pace. The housing and construction markets remain strong and auto sales are running near record levels. After years of stagnating, wages have started to rise.
"The only missing ingredient was inflation, and we got a dose of that today," J.P. Morgan's Wanshel said. "In hindsight, it was only a matter of time before some of these gains started to show up in the numbers."
Did the market overreact?
To be sure, some experts said investors may have overreacted, and noted the Fed was unlikely to raise rates based on one month's data. The Fed might not even change its "bias" toward raising rates from its current neutral stance.
The "core" rate of inflation, for example, excluding food and energy costs, "doesn't strike me as particularly strong," said Susan Phillips, dean of George Washington University's School of Business and Public Management and a former Fed governor. The core rate rose 0.4 percent last month on surging apparel, tobacco and lodging prices, the Labor Department said in its report.
"If this is the beginning of an upward trend rather than just a blip, then the (Fed) board will be looking very closely," she said. "I think there will be a variety of things they'll be looking for to build a case, but at this point all you have is one month's CPI."
Just a week ago, Greenspan warned that inflation -- the kind that comes as wages rise and prices follow -- was more than likely looming around the corner.
"At some point, labor market conditions can become so tight that the rise in nominal wages will start increasingly outpacing the gains in labor productivity, and prices inevitably will then eventually begin to accelerate," he said.
While some said the Fed may not move Tuesday, the bond market's reaction was justified, S&P's Palombi said. Bond prices have fallen and yields risen as investors concluded there was little chance of continued strong growth without inflation. Inflation is a bond investor's worst enemy, since it erodes the return on the bondholder's investment.
Stocks also benefit from benign inflation. As prices for goods remain stagnant, firms are forced to boost productivity to churn out more goods and make more money without raising prices. Higher interest rates make borrowing more expensive, which makes that push for productivity all the more difficult.
Some analysts said the April report may not be as inflationary as it seems at first glance. Charles Reinhard at ABN Amro said the inflation report was "a one-time snap-back" after months of lower-than-expected inflation numbers.
"The overall trend remains the same," he said. Many of the price gains were one-time and are not going to repeat. Nonetheless, "it's still Greenspan's call," he said. "We're nearing the low floor of the CPI."
Sudden change of heart?
Fed policy-makers as recently as February were saying that higher productivity had in effect offset increases in labor costs, according to minutes of the central bank's meeting. That view may be more muted at Tuesday's meeting, analysts said, though few expect the Fed to raise short-term rates.
At most, they say, the Fed will officially adopt a bias toward tightening monetary policy, meaning its next change would be to raise rates in a bid to slow the economy and ward off inflation.
"There's still a chance of a rate hike, you can never officially rule that out, but for the moment it appears the worst-case scenario will be an announcement of a tightening bias," Palombi said. "I don't see that happening, but that would be the worst-case scenario."
--by staff writer M. Corey Goldman
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