Suddenly, Inflation Isn't The Market's Bogeyman

The good news is that inflation is less of a worry. The bad news is that economic growth is more of one.

The change in perception comes as investors prepare for the release of key inflation data this week. The October producer price index, which measures inflation at the wholesale level, is due out Wednesday, followed by the consumer price index, the most widely watched inflation measure, for the same month on Thursday.

Cash Register
Paul Sakuma
Cash Register

Economists expect the PPI--to be released at 8:30 am New York time Wednesday--to rise 0.3 percent, versus 1.1 percent in September. Excluding food and energy, the consensus forecast is for a gain of 0.2 percent, up from 0.1 percent the previous month, according to a survey by

The CPI, due out at 8:30 am on Thursday, is likely to rise 0.3 percent on a headline level and 0.2 percent excluding food and energy, duplicating the September readings.

'The Worst Is Over'

“The worst is over with inflation,” says David M. Jones, president and chief economist at DMJ Advisors. "There was always more concern about inflation than there was inflation."

That view partly reflects the Fed’s current thinking on inflation, which Fed Chairman Ben Bernanke laid out last week on Capital Hill. In his prepared text, he cited “modest improvements in core inflation” and “inflation expectations that appeared reasonably well anchored.”

Recent data, despite the seemingly unstoppable rise in crude oil prices, support that view.

The personal consumption expenditures index -- an inflation gauge watched closely by the Fed – has now been below 2.0 percent on a year-on-year core basis – for four consecutive months. Excluding energy and food, the PCE index peaked in February 2007 at 2.5 percent.

The more consumer-friendly gauge – the Consumer Price Index – came in at 2.1 percent in September, if you exclude energy and food.

Those measures are important because they are above or below the high end of Bernanke’s supposed target range for inflation of 1 percent to 2 percent.

Slowdown in Economy

The improvement in inflation may not come cheap. Bernanke also made it clear that he expects economic growth to “slow noticeably” in the fourth quarter and remain “sluggish” during the first part of next year.

Through the first three quarters of this year, the economy has grown 2.75 percent, the least since 2003. Jones, for one, is expecting 1 percent growth at best in the first quarter of 2008.

If Bernanke’s forecast pans out, says Ram Bhagavatula, another veteran Wall Street economist, who is now managing director of the hedge fund Combinatorics Capital, "then core U.S. inflation numbers will improve.”

Bhagavatula and Jones both expect weakening demand to help cool the price of crude oil and other commodities, which for years have partly benefited from a speculative plays by hedge funds and momentum investors.

Jones thinks “the last wave” of such speculation is now running its course, while Bhagavatula says with the weakening economy, oil is “purely a tax” because “the pass-through flexibility is not just there.”

Oil Flirts With $100

Crude oil prices may have flirted with the $100-a-barrel level recently, but that may be more a case of drama than tragedy.

After all, high energy prices and double-digit annual increases have been a constant since 2003. What’s interesting is the consistency of those increases.

Through the first nine months of this year, the CPI energy index is up 11.7 percent. That compares with increases of 11.2 percent in 2006, 10.0 percent in 2004 and 12.2% in 2003.

The big exception is 2005, when the index rose 17.0 percent. That happens to be the year when headline CPI hit its recent high of 3.4 percent.

The last time the energy index fell was 2002, a year the core rate of CPI registered 2.4 percent, which is higher than most recent years.

“Oil prices really haven’t spilled over to the degree people thought,” says Jones.

Effect of Weak Dollar

Recent concerns about the weak dollar and high commodities prices may be over-stated as well as short-lived.

“I don't look at that as a major driver of inflation,” says Bhagavatula, who adds that the direct effect of commodities prices on broader inflation measures is pretty trivial.

In September’s CPI report, commodities as a group showed a 2.2 percent increase, which is roughly consistent with previous years -- 2.4 percent for all of 2006 and 2.3 percent in 2004 and 1.0 percent in 2003.

Commodities are not a threat, says Jones. “The big threat is the downside risk to growth.”