Rising inflation rekindles a big market fear from the 1970s

  • The 2.1 percent January rise in the consumer price index pushes the economy toward a potential danger zone for inflation.
  • A combination of rising price pressures and weakening growth would be a sign of stagflation, a fear from the 1970s.
  • Fed economists expect GDP to grow 2.5 percent in 2018, though the Atlanta Fed has sharply cut its projection for the first quarter.

January's hotter-than-expected consumer price index reading pushes the economy closer to a potential danger zone for the stock market.

Prices rose 2.1 percent over the past year, the same as December but more than what Wall Street had expected and at a particularly ticklish time.

This year's wicked market swings have been fed in large part by inflation fears. Rising price pressures have generated worries that the Federal Reserve might have to play catch-up on rate hikes, and Wednesday's data reinforced that perception.

While the sustained pace above 2 percent might not be cause for immediate concern, a rise in inflation toward the 3 percent level would be, according to Jim Paulsen, chief investment strategist at Leuthold Group.

Research going back to 1870 shows that as inflation morphs from 2 percent to 3 percent, investors get more sensitive to rate increases and the normal correlation of risking stocks and rising yields breaks down.

"This implies that good news may continue to be bad and any further rise in yields should prove increasingly challenging for the stock market," Paulsen told clients in a note Monday.

Reached Wednesday after the CPI release, Paulsen said the inflation numbers coupled with an unexpected 0.3 percent January retail sales decline raised the ugly specter of stagflation. The term, a market bugaboo in the 1970s, refers to high inflation and lower economic growth otherwise.

"Expectations are so high for growth. What happens if we not only get a little trickle of inflation but we start to get weaker-than-expected real growth numbers?" he said. "I'm not saying we're going to have big stagflation, but we may have to revise down aggressive growth for the year."

Paulsen wasn't alone: David Rosenberg, chief economist and strategist at Gluskin Sheff, said in his daily note that the economy was seeing "stagflation, or at least a mild case of it," based on the difference between the retail sales and CPI readings.

A trader uses his phone outside the New York Stock Exchange (NYSE) in New York.
Brendan McDermid | Reuters
A trader uses his phone outside the New York Stock Exchange (NYSE) in New York.

As things stand, Fed economists expect GDP to grow 2.5 percent in 2018, according to projections in December. That was revised up from the 2.1 percent estimate in September.

However, the Atlanta Fed just sharply cut its expectations for first-quarter growth. Its GDP model just a few weeks ago had been projecting 5.4 percent growth, but that was sliced first to 4 percent then 3.2 percent after the data releases Wednesday.

Wall Street had been slowly coming around to the prospects of faster-than-anticipated growth both in the economy and inflation for 2018. A 2.9 percent average hourly earnings increase in January especially stoked inflation worries.

Should the benchmark 10-year Treasury note yield continue to trek to 3 percent, that would indicate the recent stock market losses "have a little further to go." The S&P 500 is down about 5 percent for February.

To be sure, the January numbers aren't conclusive on inflation trends.

One of the biggest drivers in the increase, a 1.7 jump in clothing, is a classic seasonal move that could unwind in subsequent months. The price gain was hard to square with the sales decline, indicating the data are noisy and could be revised ahead.

"We believe that the higher inflation reading in January is unlikely to be the start of a new trend and, while we do believe that inflation is likely to continue to inch higher over the 2018, do not see a sharp, sustained, move in inflation as a likely outcome this year," Drew Matus, chief market strategist at MetLife Investment Management, said in a note.

Market reaction provided few clues.

Stocks sloshed around in morning trading, with the Dow industrials opening down more than 100 points before going positive then trading around breakeven at 11 a.m. ET. Bonds that are indexed for inflation, called Treasury Protected Inflation Securities, also were little changed.

WATCH: Economist Joe LaVorgna sees inflation scare overblown.