Inflation and the Fed

May was very unkind to investors.  The S&P 500 declined 3.1% making it the worst monthly decline since 2004.  The Dow Jones 30 fared a little better, declining by 1.6%.  The NASDAQ has been on its longest decline since 1994.  With inflation fears running high, uncertainty about how close the Fed will come to ruining the economy, high energy and commodity prices, and fears of what will happen in Iran, Iraqall piled on after the Fed’s May 10th meeting to send many to the exits.  The biggest losers were the emerging markets as investors feared that investors’ capital would leave these risky markets as interest rates rise. 

If inflation is the catalyst, how real a threat is it?  So far it has only popped up in a couple of minor core areas, primarily in rents.  Energy and commodity prices are high, but so far businesses and manufacturers have not passed them along to customers.  Productivity growth, the surest defense against inflation, continues very strong.  Yesterday’s report of non-farm productivity showed a 3.7% increase.  It has averaged about 3% since the mid-1990s, providing a strong deterrent to inflation.  Today’s report on employment also showed that job growth was slowing as was wages.  Employers are reluctant to hire when they believe the economy will cool.

A big driver of the inflation threat has been the increasing utilization of scarce resources such as workers.  Today’s report shows some easing in the labor market and may give the Fed reason to pause or cease their 17-month interest rate tightening cycle.  The hope among more optimistic strategists and economists is that the economy will slow to a rate of growth that remains healthy and non-inflationary.  Ed Yardeni points out that recent studies of purchasing managers shows that they continue to purchase because their businesses are booming in both the US and Europe.   They are paying higher prices for their materials, but offsetting them with productivity.  When they were asked which materials were in short supply in May, they came up with a list of only three items: particle board, stainless steel, and steel.

Today, yields on two-year treasuries which are the most sensitive to rates set by the Federal Reserve declined by the most in five weeks.  According to Bloomberg, interest rate futures show that only 46% of investors expect the Fed to push its main rate to up another quarter percent to 5.25% when they meet again at the end of this month.  The market seems to be confirming a slowing of the economy and is sending the Fed a signal that it’s time to stop.

Mr. Bernanke tells us that he and the Fed will be data driven as they form their monetary policy.  The stock, bond and futures markets are beginning to speculate that a pause is in order.   The economy and corporate earnings appear strong enough to sustain an additional rate increase or two, but are they necessary?  In just four weeks we will at least know the Fed’s answer to the question.