Will Inflation Spoil the Party?

Back in mid July we suggested the Fed might pause at its August meeting. On August 8th they held their benchmark lending rate at 5.25%, while saying that consumer prices will “moderate over time” because of their 17 prior rate increases, surging energy prices and a cooling housing market. In the eyes of many the move was a bold one for new Fed chief Ben Bernanke. Inflation hawks (those who believe inflation is worse evil than slow economy) immediately criticized his decision as a gamble that could jeopardize the Fed’s credibility as an inflation fighter. Yet, as the data have come in, the decision seems all the wiser. Both the Producer Price Index and the Consumer Price Index showed that inflation unexpectedly dropped last month. Housing starts slid 2.5% last month for the fifth time in six months. And yesterday, Conference Board said its index of leading economic indicators dropped in July.

According to Bloomberg, investors are split about 50/50 as to whether the Fed is finished raising rates or whether they will lift again. Yields on interest-rate futures contracts suggest a 53 percent chance the Fed will lift its rate to 5.5% by year-end. Fed officials still consider the dangers of faster inflation outweigh the risk of a significant economic slowdown. Companies say they need to raise wages to attract workers, and have the ability to pass along those costs to consumers, Dallas Fed President Richard Fisher said in a speech in Dallas yesterday.

But that’s only if the economy doesn’t slow and it is slowing. Gross domestic product slowed to an annual rate of 2.5% last quarter, down from 5.6% in the prior three months. As Bloomberg points out, Fed officials anticipate growth in the second half will stay around the second-quarter rate, eventually containing inflation, according to forecasts presented to Congress in July.

The yield curve is inverted and whether or not it signals recession, as it has in the past, it does indicate a significant drag on the economy. The Fed is allowing the money supply to grow and combined with the pause, and hopefully cessation or rate increases, maybe we will get by with a “soft landing” instead of a hard one or worse.

Given the strength this economy has shown over the past several years of ‘perfect storms’ it seems a fair bet that the soft landing is possible. But as our economy slows, the economies of India and China continue to grow as do their two primary resource providers Brazil and Russia. Perhaps their growth will sustain US exports and provide just the push necessary to maintain momentum.

We are currently weighted more heavily toward value stocks which continue to outperform their growth counterparts. Until the Fed begins actively pumping money back into the economy, value should continue to outperform. While we believe the shift in policy toward loosening has already begun, we will wait until there is considerably better evidence before moving more toward a growth stance.