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[TTHQ Staff]

BEING STREET SMART
____________________

Sy Harding

THE FED HAS TRIED TO WALK THIS TIGHTROPE BEFORE! March 24, 2005.

The market saw a slice of reality this week. Inflation is out of the bottle.
Of course those who buy gasoline, clothing, food, healthcare, or construction materials, have known that for several years. The Commodity Research Bureau’s inflation index has surged up 70% over the last four years.

The Federal Reserve, which prefers to look at the government’s quirky Consumer Price Index instead, has been in denial for quite some time, noting the lack of wage inflation, and the lack of pricing power by corporations. That is, thanks to the anemic employment recovery, workers have not seen their wages rise to any degree. And although their healthcare, energy, and material prices are rising sharply, many companies have not been able to pass those increased costs along to consumers. That is most noticeable with U.S. automakers and the airlines, where discounts must even be offered to move the product.

However, other industries, notably those producing gasoline, food, or in home construction or most anything connected with furnishing or landscaping those homes, have had no problem raising prices.

This week the Fed finally acknowledged that inflation may be a potential problem. I suspect they’ve known all along. However, when the Fed began raising interest rates in June of last year it was supposedly not to ward off inflation, but merely to get rates back up to more normal levels.

The market knows better, and was nervous in advance of the Fed’s FOMC meeting this week, concerned the Fed might be more aggressive with its interest rate hike this time. However, on Tuesday, the Fed again hiked rates only ¼%, and said it believes it can continue to hike rates slowly, “at a measured pace”.

But for the first time it expressed concern about inflation, citing evidence that businesses are beginning to gain pricing power, the ability to pass their rising costs along to consumers in the form of higher prices. That’s all it took to send the markets, stocks, bonds, and gold, into a nose-dive, on fear that the Fed will have no choice but to be more aggressive with its future interest rate hikes to prevent inflation from getting out of control.

That concern received support on Wednesday when the Consumer Price Index, which measures inflation at the consumer level, was released and showed an increase of 0.4% in February, an annualized rate of 4.8%. That’s well above what economists consider to be acceptable. More worrisome, the unexpected increase in the index could not be blamed on what might have been a temporary spike up in oil and energy costs in February, since the ‘core rate’, which subtracts the cost of food and energy, rose 0.3%.

It puts the Fed in a very difficult situation.

Rising interest rates eventually slow the economy by increasing the cost of credit card debt, bank loans, mortgages, etc. That in turn slows spending and lessens the threat of rising prices. But the Fed can only go so far in raising interest rates, or it will slow the economy too much. That has happened too often in the past. The last such experience was the Fed’s string of rate hikes in 1999 and 2000, which went too far and sent the economy over the edge into the 2001 recession.

Yet rising inflation is just as big a problem for the economy, since inflation also cuts into the spending needed to keep the economy growing. As an illustration of how that works, if I pay $20,000 this year for the same amount of gasoline and food as I spent $15,000 for last year, then I have $5,000 less this year than I had last year to spend on other things.

So the Fed must try to find a balance, raising interest rates enough to slow spending enough to counter the trend of rising prices, and yet not so much as to slow economic growth too much.

There may be no such balance point where both problems can be solved, and the stock market is thinking about that.

Inflation may be too far out of the bottle to be reversed with only periodic interest rate hikes ‘at a measured pace’, while the economy, with lagging employment, record consumer debt, a record budget deficit, record trade deficit, declining U.S. dollar, declining corporate earnings, etc., is too fragile to withstand more aggressive hikes.

In its nervousness, although still near its December peak, the stock market has already given back all of its previous small gains for the year, with the S&P 500 now down 3% year-to-date, and thanks to last year’s flat and unenthusiastic market, only 3% above its level of 12 months ago. Precious little reward for the risk. The NASDAQ is displaying even less enthusiasm for what is going on. It is down 8% year to date, has given back all its gains of last year, and is back to its level of December, 2003.
The market’s response this week to the Fed’s few words acknowledging that inflation might become a concern, does not bode well for what its response might be if the Fed were to hint at, or actually take a more aggressive stance.

Yet, the market’s response to more signs of rising inflation without the Fed taking action, might be just as bad.

So there was still more support this week for my warnings through the winter to enjoy the rally while it lasts, because the market is likely to experience a serious decline when its favorable seasonal period ends in a few weeks – if not before. And that profits this year will likely have to come from positioning for the downside, in short-sales and bear-type mutual funds.

Sy Harding is president of Asset Management Research Corp., DeLand, FL, publisher of The Street Smart Report Online at www.streetsmartreport.com and author of 1999’s Riding The Bear – How To Prosper In the Coming Bear Market.