Five days after implementing tariffs on $34 billion worth of imported Chinese goods, the Trump administration released a list of an additional $200 billion worth of Chinese imports that will be subject to a 10 percent tariff. On the day of the announcement, stocks slid, but only by about a half of a percent. By the end of the week, it seemed like investors had forgotten about the announcement and instead were focusing on corporate earnings and the strength of the economy.
If you feel like things are more expensive, you are right. Despite a slightly weaker than expected inflation report in April, this year, prices have accelerated faster than Fed officials anticipated just a few months ago. Last week we learned that headline inflation increased to a 14-month high of 2.5 percent from a year ago in April, due in large part to rising gas prices. Excluding food and energy the core rate increased by 2.1 percent.
Since the Great Recession, the Federal Reserve has worked hard to boost the economy. Part of the Fed’s mission was to keep core inflation (the price of goods and services excluding food and energy), at a pace of two percent annually. Although there have been instances over the past six years when either energy or food prices jumped, temporarily raising the specter of inflation, throughout the financial crisis and the recovery, the central bank has been much more focused on deflation, which is defined as a drop in the price of goods and services. For those who were around during the inflationary 1970s and 1980s, deflation is an alien concept. But according to data released by the government last week, the near-60 percent plunge in oil prices pushed down consumer prices by 0.4 percent in December from the previous month, leaving the CPI just 1.6 percent above where it stood a year ago, below the 1.9 percent annual rate over the past ten years.
Although the idea of falling prices seems like a good thing, when deflation is persistent, it can put into a motion a scary, downward spiral. It starts when the economy cools, which prompts companies to reduce prices in the hopes of luring customers and maintaining sales volume. But as companies make less money, they could then cut jobs and/or wages, which could then cause consumers to spend less in order to service their fixed costs, like taxes and mortgages/rents.
The longer that deflation goes on, the higher the risk that consumers’ and businesses’ become accustomed to the situation and delay spending, hoping they will eventually be able to buy goods more cheaply and to invest more efficiently. They also become less willing to borrow.
The vicious deflationary cycle can mire an economy in a deep recession or even worse, a depression. As an example, between 1929 and 1933, US consumer prices fell by a cumulative 25 percent. More recently, Japanese consumer prices have been stuck for the past 20 years and the Euro Zone and the United Kingdom are both currently battling falling prices.
Besides the obvious harm that deflation can cause, the other problem is that central bankers have limited tools to fight it. (In contrast, when there is inflation, hiking interest rates may hurt in the short-term, but it is effective in combating higher prices.) In a deflationary environment, policy makers would likely return to bond buying (Quantitative Easing), which depending on the magnitude of price declines, may not stop the downward spiral. (FYI, there will be an excellent test case in the efficacy of QE coming up. This week, the European Central Bank is expected to unveil its version of bond buying to boost prices in the euro zone.)
Back to the US, where the big question is whether the current drop in prices is temporary or whether there is something scary brewing. Analysts at Capital Economics believe that odds are that while negative readings on headline inflation could persist at least for the first half of the year, “it is hard to see why this renewed slump in oil prices, which is developing against a backdrop of a rapidly improving real US economy, will lead to anything more than a temporary drop in inflation.” They are quick to point out that even when crude oil collapsed from a 2008 peak of $140 per barrel to $40, amid a deep recession, prices recovered and the economy avoided a prolonged bout of deflation.
That said, they also add that “Deflation may be just one recession away,” which is probably why Fed officials continue to err on the side of adding more stimulus to the economy than less and are taking a “wait and see” attitude towards increasing short-term interest rates. Currently, the consensus is for the first rate hike to occur in the third quarter of this year. But any indication of an economic slowdown, accompanied by a more substantial drop in core prices, could put the Fed on hold longer, to avoid a dangerous deflationary downward spiral.
MARKETS: Last week, the Swiss Central Bank’s decision to discontinue its 3½ practice of pegging the Swiss Franc to the Euro sent ripple effects throughout global markets. (The policy was intended to halt the rise of the Swiss currency, which made it difficult for Swiss exporters to remain competitive in the global market.) Meanwhile, the punk US Retail Sales report unnerved investors, who continue to worry about a slowdown in global growth.
- DJIA: 17,511, down 1.3% on week, down 1.8% YTD
- S&P 500: 2019, down 1.2% on week, down 1.9% YTD (still within 4% of all-time highs)
- NASDAQ: 4634, down 1.5% on week, down 1.5% YTD
- Russell 2000: 1176, down 0.8% on week, down 2.3% YTD
- 10-Year Treasury yield: 1.84% (from 1.97% a week ago)
- February Crude Oil: $48.69, up 0.7% on week (oil CAN rise!)
- February Gold: 1,276.90 $1,216.10, up 5% on week
- AAA Nat'l average price for gallon of regular Gas: $2.08 (from $3.33 a year ago)
THE WEEK AHEAD:
Mon 1/19: Markets closed in honor of MLK Day
Baker Hughes, Coach, Haliburton, Morgan Stanley, Netflix
2014 Tax Season begins
10:00 NAHB Housing Market Index
State of the Union address
American Express, eBay
8:30 Housing Starts
Southwest Air, Starbux, Verizon
European Central Bank Policy meeting
8:30 Weekly Jobless Claims
General Electric, McDonald’s
8:30 Existing Home Sales
If the past week’s news cycle did not rattle investors, what will? Oh sure, on Thursday when it seemed like the world was spinning out of control, the CBOE Volatility Index (VIX), which helps gauge investor fear, surged 32 percent, its biggest jump in more than a year. Then on Friday, it fell 17 percent to 12.06, far below historical norms of around 20. Evidently, geopolitical events are not sufficient to cause more than a one day stock sell-off and flight to quality, most of which was reversed on Friday. So what would it take? Maybe run of the mill inflation, which has been almost absent for the past six years, would spook investors.
Headline inflation (CPI), which includes everything you care about, is up about two percent year over year. I know what you’re thinking: Why would the central bank exclude the stuff that impacts my daily life? Surely when I am spending more on food and gas, I have less money to spend elsewhere in the economy. (A recent Gallup poll found that 1/3 of Americans said higher prices are impinging on their ability to spend on travel, dining out and leisure activities.) But the Fed is not tasked with addressing short-term price increases, like those at the pumps, or even for agricultural items like beef, pork or chocolate -- the central bank can’t be at the mercy of the weather or events in the Middle East.
That’s why during the recovery, when prices have increased sporadically, the Fed downplayed the idea of broad-based inflation, calling the higher readings transitory (like when gas spiked due to the Arab Spring). More recently after the Fed’s June policy meeting, Chair Janet Yellen said that while “Recent readings on, for example, the CPI index have been a bit on the high side,” the data are “noisy.” Translation: Stop worrying about inflation—we have it under control.
The Fed is looking for a gradual increase of core inflation, which excludes food and energy, to a pace of two percent annually. Over the past six years, core inflation as measured by the CPI or by the Fed’s preferred metric, the Commerce Department’s personal consumption expenditures price index (PCE), has remained below that level. But over the past three months, core prices have started to accelerate across a variety of categories, including shelter, airfares, clothing and medical care.
It’s not so far-fetched to see how as the economic recovery accelerates, a chain of events is likely to spur price increases. Here’s what could happen: as the labor market improves, there is likely to be an increase in wages. As people earn more money, they may be willing to spend more. An uptick in spending could be the opening that retailers have been waiting for since the recession and allow them to finally increase prices for all sorts of stuff.
While it is unlikely that any of this would create runaway inflation, despite what some inflation hawks (including the usually wrong CNBC editor Rick Santelli) have been arguing for years. Remember we’re talking about what could spook investors, who are hyper-focused on when the Fed will begin to raise interest rates. It is widely believed that the central bank will begin to nudge up rates at the beginning to the middle of next year. But if prices rise faster than expected, it may prompt the Fed to hike rates sooner and more aggressively than widely expected. If that were to occur, stock investors might take a time out from the bull market and wait to see how things shake out.
- DJIA: 17,100, up 0.9% on week, up 3.1% YTD
- S&P 500: 1978, up 0.5% on week, up 7% YTD
- NASDAQ: 4,432, up 0.4% on week, up 6.1% YTD
- 10-Year Treasury yield: 2.48% (from 2.52% a week ago)
- August Crude Oil: $103.13, up 2.3% on week
- August Gold: $1309.40, down 2% on week
- AAA Nat'l average price for gallon of regular Gas: $3.58 (from $3.67 a year ago)
THE WEEK AHEAD: The SEC is poised to impose new requirements on the $2.6 trillion dollar money-market mutual fund industry, when it votes on whether the riskiest money-market funds will have to let their share prices fluctuate; and charge investors withdrawal fees during times of stress. The government was forced to provide a backstop to money market funds during the 2008 financial crisis.
Haliburton, Hasbro, Texas Instruments, Netflix
8:30 Chicago FedNational Activity Index
Altria, Dupont, Kimberly Clark, McDonald’s, Apple, Microsoft, Coca-Cola, Verizon
8:30 Consumer Price Index
10:00 Existing Home Sales
AT&T, Boeing, Facebook, Pepsi
SEC vote on Money Market funds
Ford, GM, Hershey, Starbux, Visa, 3M, Amazon, Caterpillar
8:30 Weekly Jobless Claims
10:00 New Home Sales
8:30 Durable Goods