in fláysh’n?

Treated almost with a superstitious caution, the “I” word is avoided in conversation and print almost to the extent that it is feared by financial investors.  To say it is to give it credibility and the spread of that belief might even cause it.  If a single company is successful in passing on price increases to customers so that others follow, then industries, then sectors, then, ba da bing INFLATION!

The official line on inflation, led by the Fed chief Alan Greenspan, is that that the threat remains tame.  However, he remains wary of it.  Fed officials’ speeches and comments all week have made it as clear as possible that they will continue to raise Fed interest rate targets to reach a ‘policy-neutral’ level (that is neither too low nor too high given current economic conditions).  They fear that leaving rates too low could indeed set the stage for inflation.

A rising chorus of private economists, analysts, and journalists believe the Fed is being too patient and slow to remove the threat of an overly accommodative interest rate policy.  Joseph Schuman of the Wall Street Journal yesterday speculated that U.S. inflation may not be as tame as Federal Reserve Chairman Alan Greenspan has suggested by pointing out that import prices rose by 1.7% in August, the largest monthly rise for the index since February 2003.  While costlier petroleum was largely to blame, non-petroleum import prices rose at the fastest clip in half a year.

But practically before the ink was dry on Mr. Schuman’s story, today’s government reports suggest the opposite conclusion.  The widely watched Producer Price Index actually declined by .1% in both the broad measure and the one that removes the volatile elements of food and energy.  Economists were looking for increases of .2% and .1% respectively, but cars, computers, and gasoline prices actually fell faster than expected.  So far companies have not passed along the average 22% increase in raw materials since last year.  Greenspan told Congress yesterday that high oil prices are not causing inflation to accelerate in the economy.  But he noted that there is “no doubt” that high crude prices helped to slow the economy in recent months.  And if prices remain high, they will be a concern long term, arguing for a continued measured and patient pace of Fed interest rate increases.

The last huge bout of inflation in this country was back in the 1970’s when the baby-boom generation was busy borrowing and spending to set up households.  The government was busy doing the same thing under Fed chief Arthur Burns and an unprecedented tax-and-spend Congress.  It is argued by Don Hays of that the boomers in their 40’s and 50’s are in large part responsible for the huge anti-inflationary productivity boom that we now enjoy.

Aside from demographics, there are other unprecedented global events reshaping economists’ views on inflation.  The technology/information revolution, combined with record numbers of workers coming on line as new economies enter into world trade, are having huge deflationary effects on global and domestic prices.  While China’s seemingly insatiable appetite for raw materials caused commodity prices to rise steadily over the past few months, their rapid manufacturing development has fueled price competition, reducing prices in almost every manufacturing related industry. Indiahas made similar gains on the service side.

Quite simply, the rising productivity of the world economy is becoming the great governor of inflation, anywhere is occurs.  Because of the increased efficiencies in shipping, logistics, and finances of global trade, it is likely (barring protectionism) that inflationary pockets that develop in isolated areas will be eradicated much faster as cheaper high quality goods replace their higher priced counterparts.  WalMart, CostCo, and Target will assure it.  General Motors and Ford are quickly trying to adapt as well.

Inflation remains a possibility in any economy, but it is likely more limited in punch and duration now by the new productive world economy.  If we are correct in our assessment, indeed if Mr. Greenspan and his governors are correct, stocks are undervalued – better prices lie ahead.  The big hurdle for the market now is the uncertainty of who our next president will be.  The promised policies of the two are different enough to cause rather significant uncertainty anxieties for investors.  But at least a few appear to be placing their bets early as indicated by a notable rise in politically sensitive healthcare and defense stocks.  The Dow Jones Healthcare index is up 8% since mid-August.  We bought into the sector a couple of weeks ago simply because of its reasonable valuation.  The index is at five-year lows on nearly every fundamental ratio we watch.  There are others out there as well that offer attractive upside potential with limited downside.